Make Sure Your Future Gains Aren’t Lost in the Wash

We have seen some dramatic swings in the market this past month. Volatility has investors considering selling off stocks that are losing value each day and buying them back when they have “bottomed-out.” This strategy would, theoretically, allow you to harvest tax losses while purchasing the stock back at a lower price in the expectation that the stock can return to, and possibly surpass, its previous value. Oh, what a dream! You certainly won’t be surprised that the IRS has other plans for investors planning to execute this kind of strategy.

This article focuses on the wash-sale rule and how a series of stock transactions may end up triggering an unexpected tax outcome.

What is a wash sale?

The Internal Revenue Code (“IRC”) says that 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. You may think that this would create a capital loss that can be deducted on your tax return, but the IRC says otherwise. The loss you have incurred from selling the stock cannot be deducted and actually gets added to the cost basis of the new stock purchased. The adjustment essentially defers the loss deduction until you dispose of the new stock or securities. Let’s take a look at an example:

You buy 100 shares of Y stock for $1,000. You sell these shares for $650 and within 30 days of the date you sold the shares, you purchase 100 shares of the same Y stock for $900. Since you bought stock that was substantially identical, you cannot deduct the loss of $350 on the sale. You will need to add this disallowed loss to the basis of the new stock that you purchased for $900, therefore your new cost basis in this stock will be $1,250.

What securities are included in this rule?

The IRC states that the following securities are subject to the wash-sale rules:

• Corporate stock
• Bonds
• Mutual funds
• Exchange-traded funds (ETFs)
• Options and futures contracts
• Common stock warrants

One thing to note, the IRS treats cryptocurrency as property, therefore excluding it from the wash sale rules. Our previous article (This Week In Tax, February 4, 2022, “A Good Harvest Can Wash Your Crypto Gains Away”) goes into further detail on some strategies relating to cryptocurrency transactions.

Who does this apply to?

The wash sale rules apply to taxpayers and their spouses, as well as any corporation that either the taxpayer or spouse controls. This rule also applies to individual retirement accounts. If you sell a security at a loss in your taxable investment account a wash sale will trigger if you repurchase this security within 30 days in your retirement account, such as a 401(k) or IRA. So you cannot circumvent this rule by selling the stock at a loss in your portfolio and having your spouse purchase the stock in theirs within the 30-day time frame.

How do I know if I’m purchasing a “substantially identical” security?

As with most of the IRC, there is considerable ambiguity surrounding the term “substantially identical.” Thus taxpayers must rely on case law, Revenue Rulings, and their own interpretations of the IRC, to figure this out. The closest form of guidance we have is in Publication 550, where the IRS states:

“In determining whether stock or securities are substantially identical, you must consider all the facts and circumstances in your particular case. Ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation.”

Clear as mud. But what about mutual funds and ETFs? The IRS has not addressed these types of investments specifically, but published guidance indicates that mutual funds or ETFs are substantially identical when they have similar proportions of underlying securities or are managed in a similar fashion.

The key takeaway in avoiding a wash sale is to make sure that when a security is sold at a loss, you are not purchasing securities that are substantially similar within the 30-day time frame.

Sadly, as you can see, taxpayers cannot have their cake and eat it too. Your Marcum advisor can help clarify these rules before you begin harvesting losses that may wind up disallowed.