Wednesday, 20 January 2021

What Is the Wash Sale Rule and How Can You Avoid a Wash Sale?

What Is the Wash Sale Rule and How Can You Avoid a Wash Sale?
05 Jan
2:18

Updated on Monday, January 4, 2021

The wash sale rule is intended to prevent investors from harvesting the tax benefits of an investment loss by buying a nearly identical investment to replace it. If the wash sale rule is triggered, it can result in an unexpected tax bill because you won’t be able to claim an investment loss.

This article covers what you need to know about wash sales, from what penalties you could face to how to avoid them.

Wash sale rule definition

According to the IRS, which enforces this rule, “a wash sale occurs when you sell or trade stock or securities at a loss, and within 30 days before or after the sale, you:

  • Buy substantially identical stock or securities
  • Acquire substantially identical stock or securities in a fully taxable trade
  • Acquire a contract or option to buy substantially identical stock or securities, or
  • Acquire substantially identical stock for your individual retirement arrangement (IRA) or Roth IRA”

The wash sale rule is intended to prevent investors from reporting a loss simply for tax purposes and then replacing the stock (or other asset) they sold with a nearly identical one. Essentially, the wash sale rule prohibits inventors from harvesting a loss, while still holding the stock in their portfolio.

When you sell an investment that has experienced a loss on a taxable account, you can get a tax break. In fact, an investment loss can be used to offset investment gains (a strategy called tax-loss harvesting), and you can even offset up to $3,000 of income on a joint tax return in one year.

Investors who try to take advantage of the above tax benefit — known as tax-loss harvesting — may be inclined to sell a stock that has experienced a loss solely to reap the tax benefit, and then immediately replace it with a nearly identical asset. Doing so within that 30-day window before or after the sale, however, would trigger the wash sale rule and you wouldn’t be allowed to write off the investment loss.

For investors who are trying to get around the wash sale rule, it’s worth noting that:

  • You cannot sell an investment at a loss in a taxable account, and then buy it back in a tax-advantaged account.
  • You cannot sell stock and have your spouse or corporation buy substantially identical stock.
  • You cannot sell common stock at a loss and then at the same time, buy warrants for common stock at the same corporation.

Wash sale rule example

Ron Guay, a CFP in Sunnyvale, California, outlined a clear example of a transaction that would violate the wash sale rule. Let’s say you sold shares of Apple for a $100 capital gain, but then notice that your holding in Alphabet is in a $100 loss position. You could sell Alphabet shares to harvest that capital loss, which offsets your $100 gain from selling Apple.

“Their taxes now show $0 in capital gains,” Guay said. “They repurchase GOOG [Alphabet] shortly after the sale so they can participate in the future appreciation. The actual rule states that if you purchase within 30 days (before or after the sale that recognized the loss), the loss is disallowed.”

What is the wash sale penalty?

If the IRS detects that an investment loss is the result of a wash sale, you cannot deduct the loss on your return. And in fact, any gains on a wash sale will be taxable.

However, the loss can be added to the cost basis (which is the amount you paid for your investment and is used for tax purposes) of the new investment you bought to replace it. So if you eventually sell that new investment, you could potentially reap a bigger loss — or even owe less on the gain if the investment goes up in value.

Additionally, the holding period of the investment you sold at a loss is added to the holding period of your new, repurchased investment. A longer holding period may result in reaping the lower, long-term capital gains rate if you eventually sell, as opposed to the higher, short-term capital gains rate.

What investments are subject to the wash sale rule?

The majority of investments that can be found in a taxable brokerage account or an IRA can be subject to the wash sale rule, including:

More information about what could trigger the wash sale rule is available on the IRS website, and you may want to consult a tax advisor who can give you advice for your particular situation.

How to avoid a wash sale

Purchase a similar security that’s not “substantially identical,” like an ETF

One reason that investors might want to purchase a similar security that they recently sold at a loss is to take advantage of potential upswings in the market.

One way you can do this is by locking in a loss for a particular stock, and then investing in an exchange-traded fund (ETF) that gives you exposure to the same sector or industry — but has enough differences from that individual stock you sold that it won’t trigger the wash sale rule.

“For example, let’s say you want to lock in a loss on Exxon-Mobil (XOM) shares, but are concerned that the stock may shoot up over the next month,” said George Gagliardi, a CFP in Lexington, Massachusetts. “Other than the obvious option of not selling the shares, you could sell XOM and replace them with Chevron (CVX) or ConocoPhillips (COP).”

“An even better solution would be to purchase an exchange-traded fund that had significant representation of XOM,” Gagliardi said. One such example is the Energy Select Sector SPDR Fund (XLE), which (currently) holds a 21% position in XOM and about 25 other oil and gas companies, he adds.

Use a robo-advisor that offers tax-loss harvesting

The beauty of robo-advisors is that they automate much of the investing process — including minimizing taxes without triggering wash sale rules. A number of robo-advisors boast tax-loss harvesting tools, which aim to lower your tax burden by selling a security at a loss to offset a capital gains tax.

A core feature of these tax-loss harvesting tools, though, is that they are designed specifically to not trigger the wash sale rule. TD Ameritrade, for example, does this by potentially keeping money in your portfolio as excess cash until the wash sale period is over.

If you want to potentially lower your tax burden — but don’t want to do the heavy lifting of monitoring each transaction to make sure it doesn’t violate the wash sale rule — a robo-advisor that offers tax-loss harvesting may be a good fit for you.

Source: https://www.magnifymoney.com/blog/investing/what-is-wash-sale-rule/

Small-Business-Credit-Cards
« »

Szemere

Related Articles