The IRS created the 'wash sale' rule to prevent investors from recognizing artificial losses by first selling a security for a loss and then repurchasing the same security within a short period of time.
A wash sale is a double transaction on 'substantially similar' securities in a 61-day window. The 61 days includes the date of the trade plus 30 days before and 30 days after. This means that if you hold a stock, buy additional shares and sell it for a loss within 30 days of the replacement purchase, or you sell stock you own at a loss and then repurchase it within 30 days of the sale loss, your trade is considered a wash sale.
Wash Sales & Cost Basis
For example, say you purchase 100 shares of XYZ for $25 per share on Feb. 10. Nine days later, on Feb. 19, XYZ drops to $22 per share and you sell your 100 shares. You have a capital loss of $3 per share, or $300, which may be tax-deductible. If on Feb. 26 you bought the same security for $22.50 per share, this would be considered a wash sale because you sold and repurchased shares of the same stock within only a few days. Without the wash sale rule, the result would be that you could possibly have a tax deduction for your loss, but you would still own the shares, which is why it's sometimes called an 'artificial' loss.
With the wash sale rule in place, the loss is deferred until the replacement shares are sold. In this example, that means your $300 loss would be added to your cost basis on the shares you repurchased on Feb. 26 to get an accurate capital gain/loss figure when you sell those shares.
Normally, your cost basis is the total amount of money you have invested in the stock, calculated by multiplying the per-share price by the number of shares purchased. For the Feb. 26 purchase, your normal cost basis would be $2,250 ($22.50 x 100). However, because the purchase was part of a wash sale, your cost basis would have to include your previous losses from the 100 shares sold on Feb. 19, making it $2,550 ($2,250 + $300). Thus, when you sell the replacement shares of XYZ, you will have to calculate your capital gains or losses using $2,550 as your cost basis to account for your previous losses. A higher cost basis may potentially be beneficial in the future from a tax perspective because any capital gains will appear lower and capital losses will appear higher.
A key part of the definition of a wash sale is the phrase 'substantially similar', so it's important to understand what that means. Whenever you're selling and repurchasing shares of stock in the same company, such as XYZ in the example above, those shares are considered 'substantially similar' and will be subject to the wash sale rule. In general, shares of stock in two different companies are not considered substantially similar.
While that's fairly clear-cut, there are some situations where the distinction is less apparent. For example, in an acquisition, the shares of the parent company and the acquired company may be considered substantially similar. Also, bonds and preferred stock of a single company may be considered substantially similar if both are convertible to shares of common stock. Generally, shares of a company's stock and an exchange-traded fund (ETF) with a significant percentage of its holdings in that same company are not considered substantially similar.
Examples of Wash Sale Rules
Example# 1 - Not a wash sale
Jan. 4 buy 100 shares of XYZ for $1,000.00
Jan. 5 sell 100 shares of XYZ for $900.00
Example#1 is not a wash sale because the purchase on 1/4/2010 is the original purchase and a loss cannot be disallowed and added back to the original shares. In addition, the original buy was completely sold and in this example there were no replacement shares purchased within the 61-day wash sale window.
Example#2 - Not a wash sale
March 6 buy 100 shares of XYZ for $1,000.00
March 7 sell 50 shares of XYZ for $450.00
Although 50 shares remain outstanding, it is not a wash sale because the purchase on 3/6/2014 is the original purchase and a loss cannot be disallowed and added back to the original shares.
Example#3 - Wash sale
May 10 buy 50 shares of XYZ for $500.00
May 10 buy 50 shares of XYZ for $500.00
May 11 sell 50 shares of XYZ for $450.00
Example#3 is a wash sale because it met both requirements for the wash sale to occur: the stock was sold at a loss and the shares were repurchased within the 61-day wash sale window. The sale on May 11 was for a loss, and since there were two separate buys on May 10, the loss would be disallowed and added to the remaining 50 shares.
Wash Sales & IRAs
Wash sale rules apply to the investor rather than to a particular account when an investor holds both a brokerage account and an individual retirement account (IRA). If an individual purchases and sells shares of XYZ in his brokerage account and then re-purchases them in his IRA, this transaction would still be considered a wash sale.
For more information about wash sales, contact your local branch office.
Scottrade does not provide tax advice. The material provided in this article is for informational purposes only and Scottrade is not responsible for any errors or omissions. Contribution and income limits are subject to change without notice. Please consult your tax or legal advisor(s) for questions concerning your personal tax or financial situation.