Don’t Be Hung Out to Dry By Wash Sales

Jim Forrester, CPA

The Internal Revenue Service loves to tax capital gains, but they are just as diligent to disallow capital losses that might offset those lucrative cash cows. Case in point: the wash rule.

The wash rule prohibits traders and investors from claiming a capital loss if they buy replacement stock 30 days before or after the sale of a security. If you do so, you can’t deduct the loss; it is added instead to the basis of your replacement stock for tax purposes.

Let’s take a closer look at the wash rule and what you can do to avoid being hung out to dry.

Time frame: You may not declare a loss on replacement stock you purchased within 30 days before or after selling the original security. If you buy the replacement stock 31 days or more before or after selling the original, you’re in the clear.

Replacement stock: The wash rule only applies when you buy what the IRS calls “substantially identical” replacement stock or options. Since no two individual stocks could be considered “substantially identical,” this typically applies to mutual funds that track the same index and share a virtually identical performance pattern. Choose a replacement that tracks a different index and you’ll avoid a wash sale. If you simply bought more of the same stock and not replacement stock within the previous 30 days, it is not considered a wash sale.

New basis: Since your loss is added to the basis of your replacement stock, it’s not gone forever, but merely postponed. That comes as some relief. When you sell the replacement stock at a profit, your basis will be higher, so your taxable gain will be lower. Similarly, if you sell the replacement stock at a loss, your loss will be greater due to the inflated basis, which also spells tax relief.

Holding period: If you make a wash sale, your holding period for the replacement stock includes the period you held the original stock, thus preventing you from converting a long-term loss into a short-term loss.

Related replacement activity: Your loss may be disallowed if a relative or an entity such as your IRA buys replacement stock within the time frame.

Here’s the typical wash sale scenario: On October 20, 2004 you purchase 1,000 shares of Microsoft at $35 a share. On December 15, you sell it at $15 a share for a $20,000 loss. On January 5, 2005 you buy back 1,000 shares of Microsoft at $15 a share. Because of the wash rule, the IRS disallows your $20,000 loss. Your new basis for the repurchased stock would be $35 a share ($15 purchase price plus $20 loss on the sale), plus purchase fees.

While a typical investor may rarely encounter this scenario, an active trader may find it next to impossible to keep track of all of their wash sales.

Fortunately, traders have an option that investors do not: the mark to market (MTM) accounting method. Traders who elect mark to market accounting are not subject to the wash sale rule; instead, their trading gains and losses are treated as ordinary income, not capital gains. Since the gains and losses on all MTM holdings are “marked to market” at the end of the year whether you sell the stocks or not, there’s no reason to be concerned about whether you purchased replacement stock.

Caution is advised however: once you elect mark to market, there’s no going back short of an IRS review. If you have large capital gains carryovers, it may not be the right move for you. Consult Traders Accounting before you decide.