If there is anything good to come from losing money in the stock market, getting a tax benefit for your losses might just be that thing. Recording a loss is as easy as selling a losing investment. Getting the tax benefit, however, requires that you avoid making a critical error – tipping the wash sale rule.
The wash sale rule affects all stocks, bonds, mutual funds, and options. Any investment that can generate a taxed capital gain is affected by the wash sale rule.
How the Wash Sale Rule Works
Suppose you own 100 shares of Microsoft (MSFT) stock acquired at $35 per share. The current market price is $25, for a $10 loss per share, or $1,000. Being an enterprising investor, you realize the role of taxes in your investment performance. You know that booking this loss in a calendar year will help you cover gains made in other investments, reducing your tax burden.
To realize the loss, you sell your Microsoft stock at $25 per share and record losses of $1,000. In order to legally and rightfully record this loss on your taxes, you will have to avoid repurchasing Microsoft stock within the 30 days following your sale.
The wash sale rule is designed to prevent investors from recording a loss by selling an investment and then repurchasing the same or very similar investment within 30 days. The IRS does not want investors to make transactions just for the purpose of claiming immediate tax benefits.
Wash Sale Gray Areas
The wash sale rule does have a gray area in that the law says you cannot buy the same or “substantially identical” investments in a 30 day period. What is “substantially identical” has been the topic of a common debate in personal accounting.
To be clear, selling the Vanguard Russell 2000 ETF (VTWO) and then purchasing the iShares Russell 2000 Index (IWM) is a very clear violation of the wash sale rule. These two investments, though they have different ticker symbols and fund managers, are absolutely “substantially identical.”
However, selling Microsoft stock and purchasing Apple shares is not in violation of the wash sale rule. These companies are definitely not substantially identical. They are competitors. Likewise, the case can be made that selling Exxon Mobil (XOM) shares and buying Chesapeake Energy (CHK) is not in violation of the wash sale rule. While both make money from energy, they are different companies that produce different types of energy from vastly different operations.
What Happens if You Trigger the Wash Sale Rule?
It should be made clear that it is not illegal to make a wash sale. It is, however, illegal to claim an improper tax benefit.
Triggering the wash sale rule does not mean you lose all potential value in losing money. For the sake of example, suppose again that you have 100 Microsoft shares acquired at a price of $35. The current market price is $25.
You decide to sell your shares on June 1 for $2500, incurring a $1,000 loss. By June 21, you realize that maybe you should have held onto your shares and buy 100 for $27 each or $2,700 in total.
The original $1,000 loss does not disappear. In fact, it is simply added to your cost basis for the shares you purchased to replace the shares you sold. Thus, your cost basis for the 100 Microsoft shares is $2,700, which you paid to repurchase the shares, plus the original $1,000 loss, or $3,700. Notice that you are still holding this very valuable loss since the share price is $27, and your cost basis is $37 per share. The loss will reduce any gains on your newly repurchased shares, or increase losses should you liquidate your position in the future.
The Bottom Line on the Wash Sale Rule
The wash sale rule creates an invisible line through time that separates different investments for tax purposes. If you sell an investment at a loss and repurchase a similar investment within 30 days, the IRS says the time between buying and selling is not significant enough for an investor to claim the loss from the initial transaction. The loss is added to the cost basis for your repurchase, and thus you continue to carry it until you decide to sell the investment at a later date.
If you sell an investment at a loss and do not repurchase a similar investment within 30 days, you can claim that loss on your taxes for the year.