What is wash sale?

Profit from trading US stocks is taxable. However, not all losses can be used to reduce your tax bill. Therefore, it is important to understand the rules in order to avoid such traps. The wash sale rule is one important example.

What is a wash sale?

Assume Joe makes the following two transactions in sequence:

  1. Bought one stock at $\$100$
  2. Sold that stock at $\$80$

Then, he usually can deduct the $20 loss and thus reduce his tax bill. However, if he bought back the same stock within 30 days after the loss-making sale, e.g.:

  1. Bought one stock at $\$100$
  2. Sold that stock at $\$80$
  3. (Within 30 days) Bought back the same stock at $\$60$

then, the IRS will prohit him from claiming this $\$20$ loss. This is the so called wash sale rule because Joe ends up with the same holding as before the loss-making sell transation (i.e. own one stock) but attempts to reduce his tax bill by realizing a loss.

A trading loss can only be claimed immediately if the buy-back transaction occurred more than 30 days after the loss sale transation.

It is also important to note that:

It is imperative to note that the goal of the wash sale rule is to prevent investors from reducing the tax bill early by artifical loss harvesting. It is not to prevent investors from claiming legimate trading loss.

The cost basis

Will a trading loss always be forever lost if the wash sale rule is triggered? The answer is no. In most cases, such a trading loss will be realized eventually. In order to explain this, we need to first understand the concept of cost basis. The relevance of this concept lies on the fact that the tax is calculated based on the following formula:

(sale price - cost basis) x rate rate

In many cases, the cost basis here equals the purchase price. Then, the formula above reverts back to many people's intuitive understanding. However, if a wash sale is triggered, then the cost basis of the bought-back stock is no longer the same as its purchase price. Instead, it is adjusted to:

purchase price + wash sale loss

Taking the previous example, the wash sale loss is $\$20$. Because it is forbidden from immediately being claimed. this $\$20$ will be added to the cost basis of the bought-back transaction to make it $\$60 + \$20 = \$80$. As such, if this share is sold later at $\$90$, then the profit from that transaction will be $\$90 - \$80 = \$10$, instead of $\$90 - \$60 = \$30$. By the same reasoning, if the share is later sold at $\$70$, it will realize a lose of $\$10$.

Therefore, as we see, the wash sale loss will be pushed into the future untill either a transation is profitable or the 30-day rule is no longer triggered. If the time lagging is not taken into consideration, the wash sale rule will not alter the investor's overall profit / loss position.

However ...

A wash sale loss might be lost forever if the loss-making transaction occurred in a regular brokerage account and the buy-back transaction happened in an IRA account. This is because the cost basis in an IRA account is usually not adjusted due to its special tax status.

From a practical perspective, all brokerages are required to report wash sales and adjust cost basis to the IRS. However, currently, different brokerages do not cross check accounts owned by the same tax payer. Therefore, only the IRS may have a God's view of all the accounts owned by the same tax payer. Clearly, this reality has a practical impact on the wash sale enforcement.

In addition, not all investors who make frequent trades aim to accelerate loss claiming. These trades may just be part of their trading strategies. As such, IRS allows day traders to legally avoid the wash sale restriction by claiming certain tax status. However, this topic is beyond the scope of this article.

2018 FlexibleStudy. All rights reserved.