- The wash-sale rule prevents you from selling a stock at a loss and rebuying it immediately for tax-loss harvesting purposes.
- If you trigger the wash-sale rule, your losses are tacked onto the cost basis of the rebought stocks.
- Cryptocurrency is currently not subject to the wash-sale rule.
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Not all the investments you choose will be winners. Losses are unfortunate and inevitable when investing — but they can sometimes come with some tax benefits. For one, the IRS allows single filers and married couples filing jointly to deduct up to $3,000 of their realized losses from their ordinary income tax each year.
Additionally, you’re taxed only on net gains, so any realized losses can offset your total gains from that year. Your losses also roll over from year to year, so if you had a particularly bad year, those losses will continue to offset gains until you’ve broken even again. This softens the impact from investment losses, but can also be capitalized on through a practice known as tax-loss harvesting.
But there are limits to your loss-harvesting capabilities like the wash-sale rule. Here’s what you need to know and how to avoid triggering it.
What is the wash-sale rule?
A wash sale is when an investor sells securities at a loss and within 30 days after the sale you: buy securities that are substantially identical; purchase substantially identical securities in a trade that’s fully taxable; acquire a contract or option to purchase stock or securities that are substantially identical to the ones you traded or sold; acquire substantially identical stock for an IRA or Roth IRA.
The purpose of a wash sale is to realize these losses for tax purposes without any real change to your portfolio. Since you end up rebuying the security back at the same price that you sold it at, it doesn’t impact your portfolio positively or negatively. Congress eventually revised IRS rules in 1954 and implemented the wash-sale rule, which bars people from selling an asset at a loss and rebuying the same asset or a substantially similar asset within 30 days of the initial sale.
If you break the wash-sale rule, “essentially, the loss is disallowed,” says Nicole DeRosa, a senior tax manager at Wiss & Company. More specifically, the loss you initially incurred from the sale is added to the cost basis of the stocks that you rebought.
What investments fall under the wash-sale rule?
Though the wash-sale rule doesn’t apply to investments made within a tax-deferred brokerage account, they apply if you try to sell stocks at a loss in a taxable account and buy them in a tax-deferred account such as an IRA. It also applies if you sell at a loss and then buy financial instruments, such as options, related to that stock or a substantially identical stock within 30 days.
As of now, cryptocurrency is not subject to the wash-sale rule as it is treated as property rather than a security, and the wording of the law only includes “stocks and securities.” So wash sales involving cryptocurrency are still possible. But this may change in the future as attempts have already been made to apply the wash-sale rule to cryptocurrency.
President Biden’s Build Back Better Act included a proposal that would’ve subjected cryptocurrency to the wash sale rule. However, the bill was killed in December 2021 after Sen. Joe Manchin of West Virginia expressed his opposition.
What counts as “substantially identical” when trading securities?
Though selling and rebuying the same stock is clearly a violation of the wash-sale rule, the wording of the legislation that created the rule doesn’t outline exactly what would count as a substantially identical stock. Often, it’s up to the discretion of the IRS. An action like rebuying in the same industry you’re selling in doesn’t constitute a wash sale. “I have Ford stock, and now I want to dump my Ford stock and buy Chrysler stock. They’re clearly two completely different stocks. They’re similar, but they’re still different,” DeRosa says.
Generally speaking, substantially identical stocks are two different stocks with prices that fluctuate in relation to each other. For example, dual-class stocks, which are two classes of stock issued by the same company, would qualify as substantially identical. Additionally, if two companies are about to merge, selling the stocks from one company at a loss and buying the other company’s stock would trigger the wash-sale rule.
How to avoid the wash-sale rule
To avoid the wash-sale rule, one strategy that investors can employ is known as specific share identification. This is an investment accounting strategy where an investor holds multiple shares of a single stock that were bought at different times and different prices. So using the previous example, instead of selling your stocks at $10 for a loss, with this strategy you’re buying the $10 stock first. Then after 30 days, you sell the stocks you initially bought at $100 and realize the losses.
You can also realize your losses and put the remaining money in a similar, but not substantially identical, stock, such as stocks from a company in the same industry as the company you were just invested in. The logic behind this is that even if it isn’t the same stock, investing in a company within the same industry will yield comparable results.
For more complex tax-loss harvesting strategies, it may be helpful to enlist the help of a robo-advisor that can manage your investments when tax season rolls around.
Though the penalties incurred from triggering the wash-sale rule aren’t particularly severe, DeRosa says that it can creep up on investors who might not be fully aware of tax-loss rules. “They don’t necessarily know about the wash-sale rule until it’s in their face,” she says.