What Is a Disallowed Loss in Finance and How Does It Work?

Certain tax rules prevent investors from claiming losses on specific transactions, known as disallowed losses. These restrictions exist to stop taxpayers from using artificial trades to generate tax benefits without real economic consequences. Understanding these limitations is important for anyone managing investments or selling assets.

Transactions That Trigger Disallowed Loss

Some sales and exchanges fall under tax regulations that prevent recognizing losses for immediate deduction. These rules primarily target transactions where ownership is retained in some form or the sale lacks economic substance.

Wash Sales

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. IRS Code Section 1091 prevents taxpayers from claiming a loss while maintaining their market position.

For example, if an investor sells 100 shares of XYZ stock for $5,000, incurring a $1,000 loss, and then repurchases the same stock within the restricted time frame, the loss is disallowed. Instead, the disallowed loss is added to the cost basis of the repurchased shares, adjusting the taxable gain or loss when those shares are eventually sold.

The wash sale rule applies to stocks, bonds, mutual funds, and options but does not extend to cryptocurrencies, which the IRS classifies as property rather than securities. To avoid triggering this rule, investors can buy similar but not substantially identical securities, such as an industry-related ETF instead of an individual stock.

Related Party Sales

Losses are disallowed when assets are sold to a related party, as defined under IRS Code Section 267. Related parties include spouses, siblings, parents, children, and controlled business entities. This rule prevents taxpayers from selling assets at a loss to family members or closely held businesses solely to reduce taxable income while keeping ownership within their immediate circle.

For instance, if a taxpayer sells a rental property to a sibling for less than the original purchase price, the loss is not deductible. However, if the related party later sells the asset at a gain, the previously disallowed loss may reduce the taxable gain under certain conditions.

These restrictions also apply to closely held corporations and partnerships where the seller has a controlling interest. If a taxpayer owns more than 50% of a corporation and sells depreciated assets to it, the loss is disallowed. To navigate these rules, individuals transferring property within a family or business should consider alternative tax planning strategies, such as gifting or structuring transactions at fair market value.

Non Bona Fide Sales

A transaction must be conducted at fair market value in an arm’s-length manner to be considered legitimate for tax purposes. If a sale lacks economic substance or is arranged primarily for tax avoidance, the IRS may disallow the loss. Non bona fide sales often involve agreements where the seller retains control or a right to repurchase the asset, making the transaction more of a temporary transfer than an actual sale.

For example, if an individual sells a piece of artwork to a friend at a deliberately low price with an informal agreement to buy it back later, the IRS may determine that the sale was not genuine. In such cases, any reported loss would be disregarded, and penalties could apply if the transaction is deemed an attempt to evade taxes.

The principle of economic substance, codified under IRC Section 7701(o), requires that a transaction have a meaningful purpose beyond tax benefits. Courts have ruled against taxpayers in cases where sales were structured solely to generate artificial losses. Sellers must ensure that transactions reflect fair market conditions and do not include arrangements that suggest a lack of genuine intent to transfer ownership.

Adjusted Basis Implications

When a loss is disallowed, the tax impact does not disappear. Instead, the disallowed amount is incorporated into the adjusted basis of the asset, affecting future tax calculations. Adjusted basis refers to the value used to determine gain or loss when an asset is eventually sold.

For example, if an investor purchases shares for $10,000, sells them for $8,000, and the loss is disallowed, the $2,000 loss is added to the cost basis of any repurchased shares. If the investor later sells the new shares for $12,000, the gain is calculated using the adjusted basis of $10,000 plus the disallowed loss, reducing the taxable profit to $2,000 instead of $4,000.

Beyond securities, adjusted basis plays a role in real estate and business asset transactions. If a taxpayer sells property at a loss to a related party and later reacquires it, the new basis reflects the original cost, not the lower resale price. This prevents taxpayers from artificially resetting basis values to minimize future capital gains. Similarly, depreciation deductions on business assets must be adjusted when disallowed losses affect the basis, influencing future tax liabilities.

Reporting Requirements

When a loss is disallowed, taxpayers must still report the transaction accurately on their tax return. The IRS requires detailed documentation to ensure compliance with tax laws, particularly for investment activity, asset transfers, and business transactions. Failing to properly account for disallowed losses can lead to audits, penalties, or adjustments to future tax filings.

For securities transactions, disallowed losses must be recorded on Form 8949, which reconciles capital gains and losses. Taxpayers must indicate when a loss was disallowed under specific rules, such as the wash sale provision, by marking the appropriate adjustment code and providing an explanation. These amounts then flow into Schedule D, which summarizes capital gains and losses for the year. Brokerages typically issue Form 1099-B, reporting cost basis and proceeds, but individuals are responsible for correctly adjusting figures when a loss is disallowed.

In real estate and business transactions, disallowed losses affect depreciation schedules and asset basis calculations, requiring adjustments on Form 4797 for business property sales or Schedule E for rental activity. If an asset is reacquired or transferred under circumstances that trigger disallowance, taxpayers must maintain records demonstrating how the adjusted basis was determined. The IRS may request supporting documents, such as purchase agreements, valuation reports, or prior tax returns, to verify compliance.

Distinction Between Capital Losses and Disallowed Losses

Capital losses arise when an asset is sold for less than its adjusted basis, allowing taxpayers to offset gains and, in some cases, deduct a portion against ordinary income. These losses follow standard tax treatment under IRS regulations, with annual deduction limits of $3,000 ($1,500 for married individuals filing separately) and unlimited carryforward for excess amounts. In contrast, disallowed losses are transactions where tax rules prevent immediate recognition, requiring special treatment until future conditions allow for potential recovery.

A recognized capital loss directly reduces taxable income in the year of sale, while a disallowed loss does not provide immediate relief. Instead, its effect is deferred through basis adjustments or carried forward under specific provisions. This distinction is particularly relevant for tax planning, as taxpayers must consider the timing of transactions to maximize benefits. Strategically realizing capital losses in high-income years can provide greater tax savings compared to situations where losses are disallowed and deferred.