What Is the Tax Loss Harvesting Wash Sale Rule?
Selling securities for a tax loss? The IRS wash sale rule sets important limits. See how its application can defer or even permanently disallow your claimed loss.
Tax-loss harvesting is a strategy investors use to offset capital gains by selling investments that have decreased in value, which can lower tax bills. However, this practice is governed by an Internal Revenue Service (IRS) regulation known as the wash sale rule.
The wash sale rule, detailed in Section 1091 of the Internal Revenue Code, prevents investors from claiming artificial tax losses. It prohibits taxpayers from selling a security at a loss and then quickly buying it back, as this suggests the investor did not genuinely part with the investment.
Defining the Wash Sale Rule
A wash sale occurs if you sell a security at a loss and reacquire a substantially identical one within a 61-day period. This window covers the 30 days before the sale, the day of the sale, and the 30 days after. If a transaction meets these criteria, the IRS disallows the immediate deduction of the capital loss, regardless of your intent.
For the rule to apply, you must first sell a security for a loss. Second, within the 61-day window, you must buy a substantially identical security, acquire an option to buy one, or acquire one in a taxable trade. The rule applies on a share-for-share basis; if you sell 100 shares at a loss but only repurchase 50, the wash sale rule only applies to the loss from those 50 shares.
For example, if you sell 100 shares of a stock at a loss on June 30th, the restricted period runs from May 31st to July 30th. Purchasing the same stock on any day within this period triggers a wash sale, as the rule looks both forward and backward from the sale date.
This regulation applies to most securities, including stocks, bonds, mutual funds, and exchange-traded funds (ETFs). While brokerage firms report wash sales for the same security within a single account, the ultimate responsibility for tracking and complying with the rule across all of your accounts falls to you, the taxpayer.
Identifying a “Substantially Identical” Security
The term “substantially identical” is not rigidly defined by the IRS. According to IRS Publication 550, determining if two securities are identical requires an analysis of the facts and circumstances of each case, meaning investors must use careful judgment.
Stocks and Bonds
For common stocks, shares of the same company are always substantially identical. Selling and repurchasing shares of Corporation A within the 61-day window is a clear wash sale. The common stock of one corporation is generally not considered identical to that of another, even if they are in the same industry.
For bonds, the analysis is more complex. Bonds from different issuers are not substantially identical. For bonds from the same issuer, factors like maturity dates and coupon rates are determinative. Bonds with materially different terms, such as a 5-year maturity versus a 20-year maturity, are not considered identical.
Options
The wash sale rule extends to options. An option to buy a stock is considered substantially identical to the stock itself. Therefore, selling a stock at a loss and then buying a call option for that same stock within the restricted period triggers a wash sale.
ETFs and Mutual Funds
Two mutual funds or ETFs that track the exact same index are generally considered substantially identical. For instance, selling one S&P 500 index fund at a loss and buying a different S&P 500 index fund would likely be a wash sale, as both aim to replicate the same benchmark.
A different scenario exists when two funds are in the same sector but track different indexes. For example, one could sell a large-cap tech ETF tracking a custom index and buy a different large-cap tech ETF tracking the Nasdaq-100. Because the underlying indexes and holdings are different, they are generally not considered substantially identical, allowing an investor to harvest a loss while maintaining sector exposure.
Tax Consequences of a Wash Sale
When a wash sale occurs, you cannot deduct the capital loss on your current year’s tax return. Instead, the loss recognition is deferred through adjustments to the cost basis and holding period of the replacement security.
Disallowed Loss and Basis Adjustment
The disallowed loss from the wash sale is added to the cost basis of the new, substantially identical security. This adjustment increases the investment’s cost for tax purposes, which will reduce the future taxable gain or increase the future loss when the replacement security is sold.
For example, you buy 100 shares of XYZ for $5,000 and sell them for $4,000, creating a $1,000 loss. Ten days later, you repurchase 100 shares of XYZ for $4,200, triggering the rule. The $1,000 loss is disallowed and added to the cost of the new shares, making your adjusted cost basis $5,200 ($4,200 + $1,000).
Holding Period Adjustment
The holding period of the original shares is also added to the holding period of the new shares. This determines if a future gain or loss is short-term (held one year or less) or long-term (held more than one year). Long-term capital gains are typically taxed at more favorable rates.
Using the previous example, assume you held the original shares for eight months. When you buy the replacement shares, their holding period starts at eight months. If you hold the new shares for five more months, your total holding period becomes 13 months, potentially allowing a future gain to qualify for lower long-term capital gains tax rates.
Navigating the Rule Across Different Accounts
The wash sale rule is not confined to a single brokerage account. The IRS applies it across all of an individual’s accounts, including retirement and spousal accounts, requiring investors to track their activity across their entire financial landscape.
Spousal Accounts
The IRS treats a married couple filing jointly as a single entity for the wash sale rule. If you sell a security at a loss and your spouse buys a substantially identical one in their account within the 61-day window, the rule is triggered. Your loss will be disallowed, and the basis adjustment is applied to your spouse’s new shares, preventing couples from shifting assets to generate a tax loss.
Retirement Accounts (IRAs, 401(k)s)
The wash sale rule also involves retirement accounts like traditional or Roth IRAs. According to IRS Revenue Ruling 2008-5, buying a security in an IRA can trigger a wash sale if you sold an identical one at a loss in a taxable account within the restricted period. The consequences of this are more severe than a standard wash sale.
If the replacement security is purchased inside an IRA, the loss from the sale in the taxable account is permanently disallowed. You cannot add the disallowed loss to the cost basis of the new shares because the basis of assets within an IRA is not tracked for capital gains purposes. This means the tax benefit of the loss is gone forever.