I have a question regarding the wash sale and the exercise of incentive stock options. What if the price of the stock then goes down after the day of exercise (but is still above your ISO price)? If you sell the shares at the lower current price and then immediately repurchase them, are you subject to the wash-sale rules?
-- Scott Farrar
Nothing like a simple question on a holiday weekend. Yeah, right!
Although there's nothing written, experts believe that you would be subject to the wash sale if you sold the shares at a loss and bought them back within 30 days of the sale.
In simplest terms, the wash sale says that if you sell a stock at a loss, you can't use that loss on your tax return if you buy that same security back within 30 days. So regardless of whether you're dealing with incentive stock options or shares of
, the same rules apply.
But since there are some complicating factors, let's start from the top.
Employees are granted incentive stock options, or ISOs, to buy company stock at a contracted price sometime in the future.
To qualify for the preferential long-term capital gains rate of 20%, employees must hold their ISOs for two years from the day the options were granted, and one year from the date of exercise. In many instances, employees don't owe tax on the exercise of the ISOs until they sell the actual shares. (For more on ISOs, check out this previous
Unless, of course, they fall victim to the irksome alternative minimum tax.
AMT was created years ago to make sure that everyone -- even the super rich -- paid at least some income tax. The
Internal Revenue Service
requires those with large deductions also to calculate their tax bill under AMT rules, which don't allow any standard or personal exemptions. You also don't get a credit for any state taxes paid, nor are you allowed to take any miscellaneous itemized deductions.
The worst part is that an ISO's spread, a.k.a. the difference between the exercise price and the stock's market price on the day of exercise, also must be included as taxable income for AMT.
Are you subject to AMT? First calculate your tax bill the normal way, then calculate it following the AMT rules: You must pay the higher of the two amounts. The AMT rates max out at 28%, while the regular tax rates can be as high as 39.6%. But since you can't use many of your deductions and credits when calculating AMT, the lower tax rate doesn't help you much. (Check out
-- Alternative Minimum Tax - Individuals
-- for the skinny on the calculation.)
But don't let this pesky AMT cloud your investment decisions, says Rande Spiegelman, a senior manager in
investment advisory services group in San Francisco. It's just a timing issue. If you pay AMT, you're essentially paying your taxes up front. When you sell the shares, you'll get a credit back for the tax you've already paid, so hopefully you won't owe too much more.
It's time for an example. Let's assume the exercise price on your options is $1. In January 2000, the stock is trading at $20 and you decide to exercise.
Unfortunately, in our example, the spread between your exercise price and the stock's price on the day you exercise is large enough to bump you into AMT. So you'll owe AMT on that $19 ($20 - $1) when you file your tax return in April 2001. For AMT purposes, your new cost basis in the stock is $20.
By July 2000, the stock has slipped to $10. Now you're faced with an investment decision.
If you believe it's not going any higher, you could "disqualify" the position and sell the shares immediately. You will owe ordinary income tax on the difference between your exercise price and the stock's value on the day of your sale. So in April 2001, $9 will be taxable at your ordinary income tax rates, which could be as high as 39.6%. The good news is that you no longer have AMT worries. Once you disqualify the position, AMT is a thing of the past.
But what if you believe the stock is going to make a comeback? You wait until February 2001. Unfortunately, the stock still is at $10.
You decide to sell. You'll owe the 20% long-term capital gains rate on your $9 spread in April 2002.
But you owe AMT in April 2001. The AMT rate is a flat 28%. With your AMT spread at $19, you'll owe $5.32.
But remember, when you pay capital gains tax on the sale of the stock in April 2002, you should get a credit back for the AMT you paid a year earlier. In this instance, you have an AMT loss because your basis in the stock is $20, for AMT purposes, and you sold at $10, says Spiegelman. Hopefully, that wipes out your tax bill. (Form 6251 will walk you through this calculation.)
So, how does the wash sale factor? Unfortunately, we're in a gray area here.
As a recap, the wash-sale rule says that if you sell a security at a loss, you can't deduct the loss on your tax return as long as you acquire a "substantially identical" security 30 days before or after the sale. (But that loss is not gone forever, so check out our
megapiece for the gory details on this rule.)
If you have already paid AMT tax on the $19 spread, selling at $10 would mean that you have an AMT loss. In our example, your AMT basis was $20 after you exercised. But then you sold the stock a year later for $10. So, for AMT purposes, you have a $10 loss, says Spiegelman. According to the wash sale rule, you can't use that $10 loss on your tax return.
If you had disqualified the position and sold the shares in July 2000, six months after you exercised, it would not be an issue. It's only because you have a higher AMT basis that you are subject to this rule.
If you do have an AMT loss but can't stand to be out of stock for 31 days, then
double up your position, suggests Spiegelman. Wait the requisite 31 days and sell your original shares.
Before you make any decisions, it is imperative that you input your numbers into
or some other tax preparation program. The facts and circumstances differ drastically for everyone, so it's important to analyze your own situation carefully.
And remember, selling stock is an investment decision. Try not to let taxes dictate your thinking.
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