What Is the Penalty for a Wash Sale?
Selling a security at a loss and repurchasing it has specific tax consequences. Learn how the wash sale rule defers, rather than eliminates, a loss deduction.
Investors selling securities at a loss may encounter the wash sale rule, a provision designed to prevent the creation of artificial tax deductions. A wash sale occurs when you sell an investment for a loss and acquire a nearly identical one shortly before or after. While often called a “penalty,” the primary consequence is a deferral of the loss, not a permanent disallowance. This article explains the mechanics of identifying a wash sale, its direct consequences, and the proper reporting procedures.
Identifying a Wash Sale Transaction
A wash sale is triggered by two specific conditions: the timing of your transactions and the nature of the securities involved. The first condition is the 61-day window. This period includes the day you sell a security at a loss, the 30 days immediately preceding that sale, and the 30 days immediately following it.
For example, if you sell a stock at a loss on April 15, the restricted period runs from March 16 through May 15. It is a common misconception that the window is simply 30 days after the sale; the look-back period of 30 days is an equally important component.
The second condition involves acquiring “substantially identical” securities. This term applies when you sell shares of a company’s common stock and then buy back shares of the same stock. The definition also extends to other financial instruments that are closely related, such as purchasing call options for the stock you just sold under IRS rules.
The Consequence of a Wash Sale
When a transaction is identified as a wash sale, the immediate effect is the disallowance of the capital loss for tax purposes in that year. This means you cannot use the loss to offset capital gains or the standard $3,000 deduction against ordinary income. The loss is not permanently forfeited but is instead postponed to a future date.
The mechanism for this postponement is an adjustment to the cost basis of the replacement securities you purchased. The disallowed loss amount is added to the purchase price of the new, substantially identical shares. When you eventually sell the replacement shares, the higher cost basis will result in a smaller taxable gain or a larger deductible loss.
Another direct consequence involves the holding period of the new shares. The holding period of the original shares you sold is added to the holding period of the replacement shares. This “tacking” of the holding period is important for determining whether a future gain or loss will be classified as short-term or long-term, which have different tax implications.
Calculating and Reporting a Wash Sale
Your brokerage firm will track wash sales that occur within a single account and report the disallowed loss amount on Form 1099-B in Box 1g. This information is the starting point for your tax filing. You must report these transactions separately on your return and cannot group them with other sales.
The primary form for this process is Form 8949, Sales and Other Dispositions of Capital Assets. For each sale that resulted in a wash sale, you will create a separate entry. You report the transaction details as they appear on your Form 1099-B, including the property description, dates of acquisition and sale, and proceeds.
On Form 8949, you make the adjustment. In column (f), you will enter the code “W” to indicate that the transaction is a wash sale. Then, in column (g), you will enter the amount of the disallowed loss from Box 1g of your 1099-B as a positive number. This entry effectively cancels out the loss for the current tax year, and the totals from Form 8949 are then carried over to Schedule D (Capital Gains and Losses).
Consider a numeric example. You bought 50 shares for $2,000 and sold them for $1,500, realizing a $500 loss. You then bought 50 replacement shares for $1,600. On Form 8949, you would report the sale, enter code “W” in column (f), and enter $500 in column (g). Your cost basis in the new shares is now $2,100 ($1,600 purchase price + $500 disallowed loss).
Special Considerations for Different Account Types
The standard wash sale rules apply to taxable brokerage accounts, but the consequences can be more severe when tax-advantaged retirement accounts are involved. If you sell a security at a loss in your taxable account and then purchase a substantially identical security within your Individual Retirement Arrangement (IRA) or Roth IRA, this transaction still constitutes a wash sale.
The difference is that the loss from the taxable account is permanently disallowed. Unlike in a taxable account, you cannot adjust the basis of assets held within an IRA because investments in these accounts grow tax-deferred or tax-free, and their basis is not tracked for capital gains purposes.
Because there is no mechanism to adjust the basis of the replacement security inside the IRA, the disallowed loss cannot be recovered. This interaction creates a true financial penalty, as the tax deduction for the capital loss is permanently forfeited. Investors must be careful to avoid this scenario by monitoring transactions across all their accounts.