This is the time of year that many investors sell some loser investments to offset their income or other capital gains, sometimes referred to as tax-loss harvesting. There is an obscure tax rule, known as the wash sale rule, that could affect how the IRS views these trades. So, here is a brief summary of how the wash sale rule works.
The wash sale rule was designed to discourage people from selling securities at a loss simply to claim a tax benefit.
A wash sale occurs when an investment is sold at a loss and, within a period of 30 days before or 30 days after the sale, the identical or “substantially identical” investment is purchased again.
Under such circumstances, that loss will be “disallowed” and may not be considered in calculating a taxpayer’s losses for income tax purposes.
An example is the easiest way to explain this rule:
Suppose Joe has a taxable brokerage account that holds 50 shares of XYZ stock with a cost basis of $500 because he bought the stock when it cost $10 per share. The stock is worth only $5 per share on July 31, and he sells all 50 shares for a total sales proceeds of $250. Joe now has a realized capital loss of $250.
If Joe purchases new shares in XYZ within 30 calendar days before the sale or up to 30 calendar days after the sale, his capital loss can’t be used to offset income or capital gains for that tax year but is deferred until he sells the new, replacement shares.
As you can see in the example, you temporarily lose the tax benefit of the realized loss, but you get it back when you eventually sell the newly purchased shares because you add the original capital loss to the new purchase price to establish your actual cost basis for the newly purchased shares. The only time that you lose the loss permanently is when you sell an investment in a taxable account, and you buy it back in an IRA.
If it sounds confusing, don’t worry. It is. That’s our tax code.
Please comment or send an email if you have any questions. Thanks!
Joe Baker, CFP®
Baker Asset Management, LLC
