By Brad Wright, CFP
Towards the end of the year, investors start thinking about selling underperforming stocks to offset their gains and help reduce taxes. Many investors then repurchase the same stocks after the loss is logged. If you’re contemplating this strategy, you need to be cognizant of the Wash Sale Rule.
A wash sale happens when an investor sells a losing security, typically at the end of a year, but it can occur at any point during the year, so they can claim a capital loss on taxes for that year. The investor then repurchases the security, after the loss is logged, but within 30 days of selling it.
To prevent abuse of this incentive, the Internal Revenue Service (IRS) instituted the Wash Sale Rule. The rule stipulates that if an investor buys the same or a substantially identical security within 30 days before or after having sold it (total of 61 days including the sale date), in any account owned by the investor or the investor’s spouse, any losses made from that sale can’t be counted against income. That means if you sell the position in your taxable account on November 1st, and then your husband buys it in his between October 2nd and December 1st, you are in violation of the rule. The IRS intends to prevent artificial losses. If you sell the position and then repurchase more than 30 days later, you’re all set.
Here’s an example:
- You have a $20,000 long-term gain from the sale of ABC stock and will owe 15% tax or $3,000.
- You sell XYZ stock for a long-term loss of $10,000, obviously owing no tax.
- You net out the two, resulting in a long-term gain of $10,000 and now only owe $1,500, at the 15% capital gain rate, as long as you don’t repurchase XYZ for at least 30 days.
What happens if your stock increases in value during the 30 days you don’t own it?
If you leave the proceeds in cash, you lose out. Investing your proceeds in something else for the 30 days is another option. In the above example, if you sold XYZ stock and bought XYZ bonds you wouldn’t be in violation, as the two are not substantially identical. The IRS doesn’t usually consider a company’s preferred stock to be substantially identical to common stock either. You could instead purchase stock in another company. You may also be able to find an ETF or mutual fund that covers your specific sector to act as a proxy.
What happens if you violate the rule?
Should you violate the rule, your loss will not be allowed to offset any gains, but you don’t completely lose out. Instead, the loss will be added to the cost basis of the shares you prematurely bought, which will help reduce future taxable gains.
Please note the following:
- The 30-day rule does not apply to capital gains. If you were to log a gain by selling a position and buy back the same security within 30 days, your proceeds will still be taxable, funny how the IRS works in their favor.
- You don’t need to wait until year-end to execute. If the market drops in March, there is nothing stopping you from acting then. The IRS doesn’t provide a specific definition of “substantially identical.”
Legally reducing your tax bill is usually a good idea, but you should always consult your tax professional prior to executing any sale of securities to benefit your taxes.
About the author: Brad Wright, CFP®
Brad Wright, CFP®, is co-founder of Launch Financial Planning, LLC, a fee-only firm located in Andover, MA. He is a frequent contributor to WCVB-TV and Mix 104-1 Radio. Brad is Chair of the Financial Planning Association of Massachusetts. Learn more about Brad at www.LaunchFP.com
The opinions penned here are for general information only and not intended to provide specific advice or recommendations for any individual. Launch Financial Planning does not prepare taxes.
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete. Any opinions are those of Brad Wright.