If you trade stocks, you need to know the wash sale rule. Stock trading is no longer limited to financial institutions and fund managers. Thanks to brokerage apps like Robinhood and SoFi, anyone can do it. As a newcomer to the stock market, though, you should familiarize yourself with the wash sale rule. Turning a blind eye to it can prove disastrous to your personal wealth.
What Is the Wash Sale Rule?
The wash sale rule is a tax rule in the United States that temporarily prohibits stock market participants from claiming capital loss tax deductions on securities sold and repurchased within 30 days. If you sell a stock for a capital loss and then repurchase the same stock or a substantially similar stock within the next 30 days, you’ll trigger the wash sale rule.
Losses from stock transactions are typically tax deductible. You can use them to offset capital gains, or you can use them to offset up to $3,000 of your ordinary income per year. If you sell a stock for a $100,000 profit and then lose $25,000 in a different transaction, for instance, the $25,000 capital loss will offset one-quarter of the capital gain amount, resulting in a net capital gain of $75,000. You’ll only have to pay taxes on $75,000 of capital gains after accounting for the $25,000 capital loss.
What Happens During a Wash Sale?
Triggering a wash sale means you won’t be immediately eligible for the tax deduction after selling a stock for a capital loss. As stated, wash sales are triggered by repurchasing the same stock within 30 days of selling it for a capital loss. When you repurchase the stock, your brokerage will automatically flag the transaction as a wash sale.
Wash sales don’t eliminate the tax deductions associated with capital losses. Rather, they defer them. The tax deductions will be added to the stocks that triggered the wash sales. You’ll incur a capital loss when you sell a stock for less than the price for which you paid it. You’ll trigger a wash sale when you repurchase the stock shortly after selling it for a capital loss. The capital loss will be added to the cost basis of the repurchased stock.
The Dangers of Ignoring the Wash Sale Rule
Turning a blind eye to the wash sale rule may result in a jaw-dropping tax bill from Uncle Sam. Wash sales become problematic when you realize a lot of capital gains and then realize a lot of capital losses, followed by repurchasing the same stock with which you incurred the capital losses. These three things also need to occur in the same year.
You may have a stellar start to the beginning of the trading year. In the latter half of the year, though, you may incur a substantial capital loss from a bad trade. In the event of a wash sale, the tax deduction associated with the capital loss will be deferred.
Here’s an example of what happens during a wash sale:
1. You realize $200,000 of capital gains from successful stock transactions.
2. Toward the end of the year, you realize a $150,000 capital loss from an unsuccessful stock transaction.
3. You repurchase the same stock or a similar stock within 30 days of selling it for a capital loss, thus triggering a wash sale.
4. You carry the new repurchased stock into the new year without clearing the wash sale.
5. The IRS will tax you on the full $200,000 of capital gains for the previous year.
Some traders assume that wash sales aren’t a concern since the tax deduction associated with them is deferred. The IRS will still allow you to claim the tax deduction; you just have to wait. The problem, however, is that you can only use capital losses to offset up to $3,000 of your ordinary, non-stock-related income per year.
In the above example, you’ll be taxed on $200,000 of capital gains for the wash sale-triggering year. The $150,000 capital loss will be deferred to the following year. But what if you don’t make any capital gains the following year?
You can use capital losses to offset an equal amount of capital gains. If you make $175,000 in capital gains the following year, the deferred $150,000 capital loss will lower your tax burden to just $25,000 of capital gains. If you don’t make any capital gains the following year, on the other hand, you’ll only be able to use up to $3,000 of the capital loss to offset your ordinary income. The remaining $147,000 of the capital loss will be carried over to the next year.
Tips to Avoid Wash Sales
The easiest way to avoid wash sales is to wait at least 30 days before repurchasing any stock that you sell for a capital loss. Wash sales have a 30-day window. Your brokerage will only flag the transaction as a wash sale if it occurs within this window.
If you’re adamant about repurchasing the same stock that you sell for a loss within the 30-day window, make sure that you clear the wash sale within the same year. Clearing a wash sale means selling the stock that triggered it and not repurchasing within 30 days. As long as you sell the stock prior to the New Year and don’t repurchase it within the next 30 days, you’ll be eligible for the tax deduction for the year in which you sold it.
Another way to avoid wash sales is to claim trader tax status with the mark-to-market election. With the mark-to-market election, you’ll have to recognize all capital gains and losses at the end of each year. Neither gains nor losses can be deferred to the following year. Therefore, the wash sale doesn’t apply. Only tax filers with the trader tax status can take advantage of mark-to-market election.
Brokerages are required to track wash sales, but that shouldn’t deter you from buying and selling stocks. Under the wash sale rule, capital losses are deferred. You can avoid wash sales by waiting at least 30 days before repurchasing stocks you sell for a capital loss or claiming tax trader status with the mark-to-market election. Alternatively, you can clear wash sales so that the tax deduction is applied to the year you repurchased the stocks.