What Are Wash Sales and How Do They Affect Your Taxes?
Learn how the IRS wash sale rule impacts investors. This regulation defers tax losses by adjusting the cost basis of a repurchased security after a sale.
Investors often seek to offset investment gains with losses, a strategy known as tax-loss harvesting. The Internal Revenue Service (IRS) has established rules to govern this practice, with the wash sale rule being a primary regulation. This rule prevents the creation of artificial losses for tax purposes. Understanding it is a component of managing investment-related tax liabilities and ensures that only genuine economic losses are claimed.
The Wash Sale Rule Explained
A wash sale occurs when you sell a security at a loss and acquire a “substantially identical” one within a specific timeframe. The rule, found in Section 1091 of the Internal Revenue Code, prevents taxpayers from claiming a tax deduction for a loss without significantly altering their investment position. The period to monitor is 61 days: the 30 days before the sale, the day of the sale, and the 30 days after.
The term “substantially identical” is a component of the rule, though the IRS has not provided a rigid definition. It applies to the common stock of the same corporation and also extends to contracts or options to buy or sell that stock. For example, selling shares of a company at a loss and then buying call options on that stock within the 61-day window is a wash sale. The rule covers not just individual stocks but also bonds, mutual funds, and exchange-traded funds (ETFs).
Tax Consequences of a Wash Sale
When a wash sale occurs, you cannot deduct the capital loss on your current year’s tax return. The disallowed loss is not permanently forfeited; instead, the financial impact is deferred. The amount of the disallowed loss is added to the cost basis of the new, replacement securities you purchased. This adjustment increases the purchase price of the new investment for tax purposes.
To illustrate, imagine you buy 100 shares of XYZ stock for $1,000 and sell these shares for $750, incurring a $250 loss. If, within 30 days, you buy 100 shares of XYZ again for $800, the wash sale rule is triggered. You cannot claim the $250 loss, so it is added to the cost of your new shares, making your adjusted cost basis $1,050 ($800 purchase price + $250 disallowed loss).
This adjusted basis will reduce your taxable gain or increase your deductible loss when you eventually sell the replacement shares. Another consequence is that the holding period of the original shares is added to the holding period of the new shares. This can be advantageous, as it might allow a future gain to qualify for lower long-term capital gains tax rates sooner.
Reporting Wash Sales on Tax Forms
Brokerage firms are required to track and report wash sales that occur within the same account for identical securities on Form 1099-B. A wash sale is indicated with the code “W” in column (1f), and the amount of the disallowed loss is shown in column (1g). This information from Form 1099-B is then transferred to IRS Form 8949, “Sales and Other Dispositions of Capital Assets.” On Form 8949, you report the details of the transaction, including the disallowed loss amount in column (g) as a positive number.
The ultimate responsibility for identifying and reporting all wash sales rests with the taxpayer. A brokerage firm will only report wash sales that happen in a single account, but the rule applies across all of a taxpayer’s accounts, including those at different firms and even those belonging to a spouse. If you sell a stock at a loss in one brokerage account and repurchase it in another, you must manually identify this as a wash sale and make the proper adjustments.
Special Considerations and Scenarios
The wash sale rule has specific implications when retirement accounts are involved. If you sell a security at a loss in a taxable brokerage account and repurchase a substantially identical one inside an IRA or Roth IRA within the 61-day window, the loss is permanently disallowed. This is because you cannot adjust the cost basis of assets held within a tax-advantaged retirement account, so the tax benefit of the loss is lost forever.
The rule also addresses situations where only a portion of the sold shares are repurchased. If you sell 100 shares of a stock at a loss but only buy back 50 shares within the restricted period, the wash sale rule applies only to the repurchased portion. The loss on 50 of the original shares would be disallowed and added to the basis of the 50 new shares, while the loss on the other 50 shares can be claimed.
Historically, the wash sale rule did not apply to cryptocurrencies because the IRS classifies them as property, not securities. This created a loophole for investors, but legislative proposals aim to close it by extending the wash sale rule to cover digital assets. If enacted, this change would align the tax treatment of crypto with that of stocks and other securities.