What Are Wash Sales and How Do They Affect Your Taxes?

Selling an investment at a loss can be a useful tax strategy, but certain transactions may prevent you from claiming the loss. The wash sale rule stops investors from selling securities at a loss and quickly repurchasing them to create artificial tax benefits. This IRS regulation applies to stocks, bonds, mutual funds, and options.

Understanding this rule is important because it affects your ability to deduct losses and impacts the cost basis of newly purchased securities, influencing future gains or losses.

Criteria That Trigger a Wash Sale

A wash sale occurs when an investor sells a security at a loss and repurchases the same or a substantially identical security within 30 days before or after the sale date, creating a 61-day restricted period. The IRS enforces this rule to prevent taxpayers from claiming losses while maintaining their investment positions.

The rule applies not only to direct repurchases but also to acquisitions through automatic dividend reinvestment plans, stock options, or purchases in tax-advantaged accounts like IRAs. If an investor sells a stock at a loss in a taxable brokerage account and repurchases it in their IRA within the restricted period, the loss is permanently disallowed rather than deferred. In a taxable account, however, the disallowed loss is added to the cost basis of the new shares.

Wash sales can also be triggered by purchases made by a spouse or a corporation controlled by the investor. If a married couple files jointly and one spouse sells a stock at a loss while the other repurchases it within the restricted period, the IRS considers it a wash sale. Similarly, if an investor owns more than 50% of a corporation and that corporation buys the same security after the investor sells it at a loss, the rule applies.

Identifying Substantially Identical Securities

The IRS does not provide a precise definition of “substantially identical,” leaving investors to assess factors such as the issuer, security type, and underlying characteristics. Stocks of different companies, even within the same industry, are not considered substantially identical. However, different classes of stock from the same company—such as common and preferred shares—may be treated as identical if they offer similar rights and privileges.

For mutual funds and ETFs, the distinction is more nuanced. Two funds tracking the same index, such as the S&P 500, could be considered substantially identical if they have nearly identical holdings and expense ratios. Replacing shares of the SPDR S&P 500 ETF (SPY) with the iShares Core S&P 500 ETF (IVV) may trigger the wash sale rule due to their nearly identical investment compositions. However, selling a broad-market ETF and purchasing a sector-specific ETF would not typically be considered a wash sale since their underlying assets differ significantly.

Bonds and options present additional challenges. A bond issued by the same company but with a different maturity date or interest rate may not be considered identical, but if the differences are minimal, the IRS could view them as substantially the same. Similarly, repurchasing call options with a slightly different strike price or expiration date does not always avoid the wash sale rule, especially if the new contract closely mirrors the original one.

Effect on Capital Loss Deductions

Losing the ability to deduct a capital loss due to a wash sale can increase an investor’s tax liability, particularly for those who rely on tax-loss harvesting to offset gains. When a loss is disallowed, it cannot be used to reduce taxable income in the year of the sale. This can be costly for individuals in higher tax brackets, where long-term capital gains are taxed at 15% or 20%, and short-term gains can be taxed as high as 37%.

Frequent traders and investors who actively rebalance their portfolios must be especially cautious. Multiple wash sales throughout the year can significantly reduce the effectiveness of a tax-loss harvesting strategy. Day traders and algorithmic investors who execute frequent trades are particularly vulnerable since the IRS does not provide exemptions for high-volume trading. Repeated wash sales can result in accumulated losses that never materialize as deductions, undermining a tax strategy they may have been relying on.

Adjusted Cost Basis After a Disallowance

When a wash sale occurs, the disallowed loss is incorporated into the cost basis of the new security. This adjustment increases the purchase price for tax purposes, which lowers the taxable gain or increases the deductible loss when the replacement security is eventually sold.

For example, if an investor sells shares for $5,000, incurring a $1,000 loss, and repurchases the same security for $5,200 within the restricted period, the $1,000 loss is disallowed. Instead, it is added to the new purchase price, resulting in an adjusted cost basis of $6,200. If the investor later sells the shares for $7,000, the taxable gain would be $800 rather than $1,800, reflecting the deferred recognition of the original loss.

This basis adjustment can have unintended consequences. If the replacement security is held for more than a year, any future gains may qualify for the lower long-term capital gains tax rate. However, if sold within a year, the gain is taxed as ordinary income, which can be significantly higher. Investors who frequently trigger wash sales may find their cost basis accumulating over time, distorting their expected tax outcomes.

Tax Filing Requirements

Reporting a wash sale correctly on a tax return is necessary to comply with IRS regulations and avoid discrepancies that could trigger an audit. Brokerages track wash sales for taxable accounts and report them on Form 1099-B, but investors must ensure accuracy when filing their returns, particularly if transactions involve multiple accounts or tax-advantaged plans.

Wash sales are reported on IRS Form 8949, which details the disallowed loss and the adjusted cost basis of the replacement security. These figures are then carried over to Schedule D of Form 1040, where capital gains and losses are summarized. If a wash sale spans multiple accounts, such as when an investor sells a stock in one brokerage and repurchases it in another, the investor must manually adjust the cost basis, as brokerages only track wash sales within the same account. Failing to make these adjustments can result in underreported income, leading to potential penalties or additional tax liability.

Possible Penalties

Failing to properly account for wash sales can lead to unintended tax consequences, including penalties for underreporting income. If the IRS identifies discrepancies between reported gains and brokerage records, it may issue a notice of deficiency, requiring the taxpayer to pay additional taxes along with interest. In cases of repeated noncompliance, accuracy-related penalties of 20% of the understated tax liability may apply under Internal Revenue Code Section 6662.

In more severe cases, if the IRS determines that a taxpayer intentionally ignored wash sale rules to manipulate tax obligations, penalties could escalate. Underreporting income by more than 25% can extend the statute of limitations for an audit from three years to six years. While criminal tax fraud charges are rare, they can carry fines of up to $250,000 for individuals under Internal Revenue Code Section 7201. Investors who trade frequently should ensure they have systems in place to track wash sales accurately, as errors can compound over time and lead to significant financial consequences.