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Ask Bev: Looking at Wash Sales, Covered Calls

Understanding tax law requires the patience of a Talmudic scholar. But one aspect in particular seems to give readers a crisis of faith unsurpassed by any religious experience -- the "wash-sale" rule.

The wash-sale rule governs the purchase and sale of different lots of the same security -- it's when you buy one lot and sell another within the next 30 days, or sell one lot and buy another within 30 days. Under the rule, if the wash sale results in a capital loss, the Internal Revenue Service won't allow you to claim that loss as a deduction. Rather, you'd add the amount of the loss to your basis in the new shares. So the benefit isn't lost, only delayed. The increased basis in the new shares ensures that you'll either owe tax on less of a gain or will be able to claim a larger loss when you eventually sell those shares.

Technically, the wash sale prevents you from claiming a loss on a security if a "substantially identical" security was purchased in that 61-day window. So if you sell 100 shares of Cisco (CSCO) at a loss but then three weeks later repurchase another 100 shares, you'll have to adjust the basis of the new shares to reflect the loss incurred in the sale, rather than being able to use it to offset gains you may have reaped in other areas of your portfolio. The "substantially identical" stipulation, though, means that it's not just buying new shares of Cisco that will trigger the wash-sale rule, but also contracts or options to buy Cisco.

In practice, the wash-sale rule has inspired more reader mail than any other subject this column has tackled. For more background, click here , here , here and here .

Beverly,

I have modest very long-term holdings in several direct dividend reinvestment programs, e.g. Johnson & Johnson (JNJ - Get Report). If I buy 100 shares of JNJ today through my brokerage account, and sell it at a loss on Feb. 17, does the wash-sale rule come into play by virtue of the small dividend received and reinvested automatically in the interim?

Thanks,

Doug D.

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