Introduction
When you trade shares or options on the same investment repeatedly, it is unavoidable that you will have hundreds or perhaps thousands of Wash Sales over the year. All of these Wash Sales must be recorded and adjusted for by the IRS on Schedule D Form 8949.
This detailed Wash Sale guide will assist you in understanding the Wash Sale Rule in day trading and how it impacts your trading and investing.
What Exactly Is the Wash Sale Rule?
The Wash Sale rule is an Internal Revenue Service (IRS) policy that prohibits taxpayers from deducting losses on securities sold in a Wash Sale. A Wash Sale happens when an individual sells or trades a securities at a loss and then buys the same or a nearly similar stock or security, or gets a contract or option to do so, within 30 days before or after the sale.
A Wash Sale occurs when a person sells a security and his or her spouse or a corporation controlled by the individual purchases a substantially identical investment during the 61-day waiting period. The rule’s purpose is to prohibit investors from incurring an investment loss in order to claim a tax deduction while retaining their position in the securities.
As an example: Assume a trader owns 500 shares of an asset worth $5,000. He sells the shares today for $4,000 in total proceeds, resulting in a $1,000 loss. He intends to repurchase the 500 shares tomorrow; the price will most likely be similar to today’s pricing.
As a result, he will still possess the 500 shares but will have lost $1,000 in capital. A savvy trader may use wash sells to collect taxable losses to balance his gains and avoid capital gains taxes.
It is difficult to determine the motivation for a Wash Sale; an active trader may move in and out of a security often, triggering Wash Sales with no idea of “harvesting losses.” Nonetheless, the IRS developed the Wash Sale rule to prevent anybody from decreasing capital gains through Wash Sales. Furthermore, the Wash Sale rule is significantly broader than our basic case above.
The Wash Sale Rule: How does it work?
The Wash Sale rule is intended to prohibit taxpayers from claiming fictitious losses on the sale of assets while retaining ownership of the instruments.
The Wash Sale rule has a 61-day deadline. That is, 30 days before and 30 days after the transaction takes place. After that time, the Wash Sale rule will no longer apply to transactions involving the same or comparable securities.
Through the Wash Sale rule may deny a loss, the amount of that loss will be added to the cost of the purchase that triggered the rule. When the position is eventually sold, any loss can be deducted as a tax deduction. As a result, the initial loss might be considered to be postponed.
The Wash Sale rule would also apply to the loss sale of options (which are quantified in the same way as stocks) and the reacquisition of identical options within the 30-day timeframe.
Can the Wash Sale Rule be applied to everything?
The Wash Sale rule applies to any form of same or nearly similar investment sold and acquired by an individual, their spouse, or a firm they control during the 61-day timeframe.
“It’s difficult to mistakenly violate the regulation [with stocks],” says Leslie Sauer, a certified public accountant (CPA). According to Sauer, the IRS makes it plain that stock must normally be from the same firm to trigger the Wash Sale rule.
To conduct a Wash Sale, you would have to sell Company A’s stock and then repurchase it. You should be alright if you bought Company B’s shares instead, even if they are in the same industry.
However, when it comes to mutual funds and exchange-traded funds, things may become a little more complicated (ETFs). You can’t, for example, sell one company’s index fund and then purchase another following the same index, or even one containing the majority of the same firms.
It’s vital to realize that the Wash Sale rule applies to all of your financial assets, from taxable brokerage accounts to 401(k) plans (k).
The Calculation of Wash Sale
The IRS requires you to keep track of every Wash Sale you make during the tax year. To begin, you must identify deals that have been closed at a loss. Then you must go back and forth in time to verify if you repurchased the same or “essentially the same” securities within a 30 day period.
If so, you must record a Wash Sale adjustment line on your Schedule D. You must also adjust the cost basis of the repurchased shares, shifting the loss forward or backward to the deal that caused the Wash Sale.
If you plan on doing this by hand, the Wash Sales calculation is difficult! However, it becomes more problematic if you do not repurchase an equivalent number of shares.
Equivalent number of shares cases
It is unavoidable for an active trader to purchase back an uneven number of shares after suffering a loss. This is when the Wash Sale rule becomes quite difficult. According to IRS publication 550, page 56.
‘More or less stock was purchased than sold. If the number of shares of substantially similar stock or securities purchased within 30 days before or after the sale is greater or less than the number of shares sold, you must decide which shares are subject to the Wash Sale regulations. This is accomplished by matching the number of shares purchased with an uneven number of shares sold. Match the shares you acquired in the same sequence you bought them, starting with the first.’
The Net Effect
This essentially divides your Wash Sales by the smallest amount of shares purchased or sold. A few simple instances demonstrate this fairly clearly:
- You purchase 100 shares and then sell them for a $200 loss. You then repurchase 50 shares during the 30-day period. What portion of the $200 loss is applied to the cost basis of the 50 shares? The correct solution is $100 (50 sh /100 sh x $200).
- What if you acquired and sold 100 shares at a loss, then repurchased 20 shares, followed by another 80 shares? The Wash Sale loss on the 100 shares is divided 20/80, with 20% going to the first 20 shares purchased and the remaining 80% going to the remaining 80 shares.
- What if you had acquired and sold 1000 shares at a loss and then bought back 200, 300, 100, and 600? What if one or more of the repurchases is sold at a loss, and you then buy back an uneven number of shares?
What Happens if You Make a Wash Sale?
If you purposefully or inadvertently violate the Wash Sale rule, the IRS will not allow you to claim that loss on your taxes in current or, if significant enough, subsequent years.
If you were banking on it to offset capital gains or lower taxable income, you may wind yourself owing more taxes than you anticipated. This can seriously jeopardize certain people’s tax-loss harvesting strategies.
However, you may still gain from your Wash Sale. You may calculate your loss by multiplying it by the cost of repurchasing the same or substantially comparable investment. This increases your cost basis, which may save you money on capital gains tax later on-or, if you sell the investment at a loss later on, you may be able to claim a larger loss than otherwise.
Is the Wash Sale Rule applicable to cryptocurrencies?
Bitcoin is not subject to the Wash Sale regulation since it is not properly a stock. This implies that cryptocurrency investors may sell their coins at a loss, claim a tax deduction for the loss, and instantly buy the same cryptocurrency.
Recent congressional plans, however, would shut this loophole as soon as January 1, 2022. These rules are not yet written in stone and are unlikely to be retroactive to 2021, so if you want to claim crypto losses in 2022 and later, consult with a tax professional beforehand.
The Wash Sale Rule’s Impact on Active Traders and Investors
Most Wash Sales have no impact on your year-end profit or loss! However, if left unchecked, the Wash Sale rule might have devastating consequences towards the end of the year. Some of your losses may be disallowed for the current tax year and postponed to a later year, raising your taxable income in the current year. This is referred to as a Wash Sale deferment.
The Wash Sale rule may have an impact on your year-end profit or loss in two ways:
- If you sell at a loss in December and then purchase it again in January, you will make a profit. If you sell a stock at a loss in December and then repurchase it in January (within the 30-day window), the loss is disallowed for the current tax year and must be carried forward, and can only be recognized in the year in which you eventually dispose of the shares you acquired in January. When you conclude a short sale at a loss in December and then get into another short sale in January, the same thing happens (within the 30 day window).
- If you have shares open at the end of the year that have accumulated Wash Sales: If you lose a trade at any time throughout the year and subsequently repurchase the same investment within the 30-day timeframe and have these shares open at year end, the whole loss is disallowed for the current tax year. The losses must now be carried forward with the open position and can be recognized only in the year in which you eventually dispose of the shares that you repurchased.
In either situation, the loss is ineligible for the current tax year and must be carried over to a future tax year. Consider the following examples to see how this might affect your bottom line:
- On December 4, 2013, you sold 1000 shares for a loss of $3,200.00. According to the IRS Wash Sale rule, if you purchase back shares of that same stock or enter into an option transaction on that same stock anytime up to January 4, 2014, all or part of your $3,200.00 loss is disallowed for the 2013 tax year and must be delayed to a later year. This implies that you actually lost this amount in December 2013, but you can’t claim it until you sell the repurchased shares in a later year.
- On March 15, 2013, you sold 1000 shares for a loss of $3,200.00. According to the IRS Wash Sale rule, if you buy back shares of that same stock or enter into an option trade on that same stock within the 30 day window and hold these shares open at year end, all or part of your $3,200.00 loss is disallowed for the 2013 tax year and must be deferred to a later year. This means that you actually lost this money very early in 2013, but you can’t accept the loss until you sell those buyback shares later in the year.
Does the Wash Sale Rule Apply to Day Traders?
The Wash Sale rule was designed with highly skilled investors and traders in mind in the majority of circumstances. However, it also applied mistakenly to regular day traders. For starters, it only applies to American traders who purchase and sell securities that have a CUSIP number.
It is applicable to traders of stocks, exchange-traded funds (ETFs), and options, among others. We urge that traders speak with an experienced tax advisor to determine how to disclose the Wash Sale regulation and how to reduce your penalties.
Is a Wash Sale 30 Days or 60 Days?
A wash-sale normally takes 60 days, including 30 days before the sale and another 30 days after the sale. The wash-rule is an IRS policy that precludes illegitimate tax deductions on securities traded in wash transactions.
In general, a wash sale occurs when an investor sells an asset at a loss and then repurchases the same or a similar investment within 30 days of the sale. Ordinarily, the IRS does not consider stocks and securities of a firm to be equivalent, unless when a company’s preferred stock can be changed to common stock without a barrier.
The wash-sale rule states that if a firm or an investor sells a security at a loss in order to buy the same or a similar security at the same price, tax deductions for such security are not allowed.
How Do Day Traders Avoid Wash Sales?
If you’re worried about triggering a wash sale, you may usually avoid it by completing one or more of the following:
Wait for 30 days
The best strategy to avoid a wash sale is to wait 30 days after selling your investment to acquire the same or a comparable one. (You’ll also want to make sure you didn’t acquire the same or a comparable investment on the day you sold or within 30 days of selling.)
Some investors may go insane if their money is left on the sidelines, so if you can’t tolerate it, put it into something completely different.
Find a Significantly Different Investment
While the IRS guideline on what counts “substantially equivalent” is not clear, the main issue is that the government doesn’t want you to obtain a tax deduction for something that isn’t actually a loss for you.
To be extra cautious, investing in a completely other business or sector will ensure that you do not violate the wash sale rule. If you’re not sure how different your alternative investment should be, Sauer recommends speaking with a financial counselor or a tax specialist. You might also use a robo-advisor to perform your tax-loss harvesting for you.
Have an Investment Strategy
Investors who are unprepared for short-term market downturns may inadvertently activate the wash sale rule if they panic sell and then repurchase the same investment once the market begins to recover.
A long-term investment strategy that you adhere to, even during market downturns, may help you make the greatest investment and tax decisions in good and bad times.
In conclusion
A wash sale happens when an investor sells a holding at a loss and then repurchases the same (or a substantially comparable) security inside the 61-day wash sale period. It also happens if their spouse or a firm they own purchases substantially identical securities during that time period.
The IRS regards this behavior as generating fictitious losses in order to obtain tax advantages. The wash-sale rule prohibits taxpayers from deducting an erroneous capital loss from taxable earnings. Investors should be aware of the wash-sale rule so that they can avoid it.
