What Is a Wash Trade? The IRS Rule & Its Consequences

This article explores wash trades, a concept that carries significant meaning in both tax law and market regulation. It explains what these transactions involve and why understanding them is relevant for investors and market participants.

Defining a Wash Trade

A wash trade involves the simultaneous or near-simultaneous buying and selling of the same or substantially identical security by the same entity or closely related entities. The core characteristic is that the person engaging in the trade does not genuinely change their economic position or market risk.

The primary intent behind such a transaction is to create a false appearance of market activity or to generate an artificial tax loss. For instance, an individual might sell shares of a company and then immediately repurchase the same number of shares at a similar price. This action gives the impression of market liquidity or a genuine transaction, even though beneficial ownership remains unchanged.

The IRS Wash Sale Rule

The Internal Revenue Service (IRS) addresses wash sales under 26 U.S. Code § 1091. This rule prevents taxpayers from claiming artificial losses by disallowing a tax deduction for losses realized on the sale of stock or securities if “substantially identical” stock or securities are acquired within a 30-day period before or after the sale date. This creates a 61-day window, encompassing 30 days before the sale, the day of the sale, and 30 days after the sale.

For tax purposes, “substantially identical” generally refers to common stock of the same corporation. It does not typically include options, bonds, or preferred stock of the same corporation, unless they are convertible into common stock of the same corporation.

When a wash sale occurs, the disallowed loss is not permanently lost but is instead added to the cost basis of the newly acquired security. For example, if an investor sells shares of Company A for $1,000, realizing a $200 loss, and then buys back substantially identical shares within the 61-day window for $1,000, the $200 loss is disallowed. The basis of the newly acquired shares would then be $1,200 ($1,000 purchase price + $200 disallowed loss), which helps defer the tax benefit until the new shares are sold.

Wash Trades as Market Manipulation

Beyond tax considerations, wash trades are also viewed as a form of market manipulation, distinct from the IRS tax rule. The intent is to deceive market participants or regulators about true supply and demand for a security. Such activities can create artificial trading volume, giving a misleading impression of interest or liquidity in a particular stock.

Regulators like the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) prohibit these actions. These bodies enforce anti-fraud and anti-manipulation rules, which encompass practices like wash trading. The concern is maintaining fair and orderly markets where prices reflect genuine investor interest.

Wash trades can also influence a security’s price by creating an illusion of active trading. This can lure unsuspecting investors into buying or selling based on fabricated market signals. Regulatory bodies focus on the deceptive nature of these transactions and their potential to harm market integrity.

Consequences of Engaging in Wash Trades

Engaging in wash trades can lead to various repercussions. For instances related to the IRS wash sale rule, the primary consequence is the disallowance of the claimed tax loss. Misreporting on tax returns due to an unaddressed wash sale can lead to accuracy-related penalties, which may be 20% of the underpayment of tax attributable to negligence or substantial understatement.

When wash trades are used for market manipulation, the consequences are more severe. Regulatory bodies can impose significant fines and civil penalties. Individuals or entities may be required to disgorge any ill-gotten gains derived from the manipulative activity. In serious cases, criminal charges can be filed, potentially leading to imprisonment and substantial financial penalties.

Avoiding Wash Trades

Investors can avoid inadvertently engaging in wash trades, particularly concerning the IRS wash sale rule. Carefully track buy and sell dates for securities, especially after realizing a loss. Understand what constitutes “substantially identical” for tax purposes when considering repurchasing a security. Be mindful of the 30-day rule before and after a loss-generating sale to avoid disallowing the loss.

For market manipulation, ensure all trades have a legitimate investment or business purpose. Avoid actions that could create a misleading impression of market activity, such as trading with oneself or related accounts. Adhering to these guidelines helps maintain compliance with both tax laws and market regulations.