Understanding the Wash Sale Rule

| November 28, 2012 | 0 Comments

The IRS wash sale rule prohibits traders/investors from deducting losses from sales or trades of stocks or securities in a wash sale unless the trader is a dealer in stocks or securities.  A wash sale occurs when a trader sells a stock or security at a loss and within 30 days before or after the sale she does one of the following:

  1. Buys substantially identical stock or securities
  2. Acquires substantially identical stock or securities in a fully taxable trade
  3. Acquires a contract or option to buy substantially identical stock or securities, or
  4. Acquires substantially identical stock for your individual retirement account (IRA) or Roth IRA.

If an investor sells a stock and his/her spouse or a corporation he/she controls buys substantially identical stock, they also have a wash sale and cannot deduct the loss when filing tax returns.

Understanding what trades qualify is less complicated than it sounds.  For example, "substantially identical" does not refer to selling AT&T and buying Verizon.  While similar in what each company does, they are not substantially identical.  Buying in the money call options or selling in the money put options on AT&T would substantially identical because the change in price would be similar for both and would be affected by how AT&T's price moves.  The potential for gains and losses would be similar, to a certain point, with the use of in the money options on the same stock or security.  Selling an S&P 500 Index ETF and buying a Russell 2000 Index ETF are not substantially identical.  Both cover indexes, but the indexes are different in the companies they track.  Selling the ETF SPY (managed by State Street Global Advisors) and buying the ETF IVV (managed by iShares) would be considered substantially identical because both track the same index.

Officially, if a loss was disallowed because of the wash sale rules, an investor can add the disallowed loss to the cost of the new stock or securities (except in (4) above). The result is a basis in the new stock or securities. This adjustment postpones the loss deduction until the disposition of the new stock or securities. Your holding period for the new stock or securities includes the holding period of the stock or securities sold.  It's better to avoid such paperwork headaches for most investors and pay attention to when losses are taken.

At the end of calendar years, many investors like to sell their stocks or securities that have accumulated substantial losses for the tax write-off benefit.  However, no one who has held the position for such losses wants to miss any rebound in the price.  To remove the upside risk, an investor can use options and buy a call option that expires more than a few months away, but has to do so at least 31 days before she sells the shares.  31 days after buying the call options that represent the equivalent amount of shares, she can sell the shares, take the loss and then 31 days later can buy the shares back and sell the call options.  This gives ownership rights to shares at a certain price in the future, but reduces the downside risk.  If the investor is lucky, the shares and calls will increase in price prior to selling the shares.  If this happens, the investor can take the gains on both the options and the original shares.

This option strategy has risks.  Be sure to speak with your Investment Advisor before attempting this strategy if you are not fully aware of the risks involved in investing with options.

Filed Under: Investing 101


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