Death & Taxes

Wash Sales

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By Roy Lewis

When there's a stock market (insert your own adjective here: crash, blip, downturn, correction, buying opportunity, etc.), many of you may find yourselves holding stocks that you really like from a fundamental standpoint, but that are now worth less than what you initially paid for them. What to do?

Then, all of a sudden, your brain crosses a red and black wire, and a flash appears. You say to yourself, "Self, I'll just sell these shares, take the loss on my tax return, and then immediately buy those shares back. I'll be able to keep the stock I really like and take a tax loss all at the same time. Sweet."

My advice: Don't do it unless you know the rules. You might run afoul of the wash sale rules. "What?" you may say. We're not talking about beating our shirts against a rock here, we're selling stock!

And, while that very well may be true, Uncle Sammy doesn't see the humor in the fact that you're retaining your economic position in your stock while buying yourself a tax deduction with no risk to you in the future. Therefore, to close this glaring loophole, the Feds long ago named this transaction a "wash sale" and deemed that any loss on a wash sale could not be currently recognized.

Wash Sales

Under the wash sale rules, if you sell stock for a loss and buy it back within the 30-day period before or after the loss-sale date, the loss cannot be immediately claimed for tax purposes.

This rule is designed to prevent you from selling stock to claim the loss and then buying it back within a short period of time to retain ownership. Note that the rule applies to a 30-day period before or after the sale date, to prevent "buying the stock back" before it's even sold.

This might sound outrageously unfair to you. After all, if your money was plunked into the stock, and your dollars were lost, how can it be that you're not allowed to claim the loss?

You do get to claim the loss -- just not now. Although the loss can't be claimed on a wash sale, the disallowed amount is added to the cost of the repurchased stock. So, the loss can be claimed when it is finally disposed of, other than in a wash sale.

Example: Larry Laundry buys 500 shares of ABC Corp. for $10,000 and sells them on June 5 for $3,000. On June 30, he buys 500 shares of ABC for $3,200. Since the stock was "repurchased" within 30 days of loss-sale date, the wash sale rules apply. Larry can't claim his $7,000 loss. Instead, he must adjust his basis in the repurchased shares. His basis in his "new" 500 shares is $10,200 -- the actual cost, plus the $7,000 disallowed loss.

Larry would also be in violation of the wash sale rules if he purchased his "new" shares on June 1 and then made the loss sale on June 5. Remember, the rule is 30 days before or after the date of the loss sale. But, also remember that if Larry had waited the required 30 days before he "repurchased" his shares, there would be no wash sale.

Buy Fewer Shares

But, how about if you repurchase fewer shares than you originally sold for a loss? Is all of the loss disallowed? Nope. Only the portion of the loss attributable to the "washed" shares will be disallowed. If you only buy back a portion of the stock sold, then only that portion of the loss is disallowed.

Thus, in the above example, if Larry only bought back 300 of the 500 shares (60%), he would be able to claim 40% of the loss on the sale ($2,800 under the facts above). The remaining $4,200 of the loss disallowed under the wash sale rules would be added to Larry's cost of the 300 shares, and Larry's basis in the new shares would be $6,120 (the cost of the original 300 shares of $1,920 plus the disallowed loss of $4,200).

As you can see, if you're doing a bunch of trading in a specific stock (not very Foolish, by the way), the wash sale rules can really jump up and complicate your life. Buying and selling, different numbers of shares, different prices, gains, and losses, basis adjustments, yada, yada, yada. Whew way too much work for many people.

Burning Bridges

But, and this is a very big "but," the wash sale rules really become moot if you close out your entire position in the stock prior to the end of the year... and then stay out of the stock for the required 30-day period before or after the date of the loss sale.

Let's look at Larry again. He certainly has a wash sale in the example above. But, let's say that Larry tires of his position in ABC Co. and sells his 500 shares on December 20th of the same year for $4,000. Larry's adjusted basis in the shares is $10,200 based on his wash sale computations, and his overall loss would amount to $6,200.

But, if you break down the two separate "buy" and "sell" transactions, you see that Larry generated a loss of $7,000 on the first transaction, and a gain of $800 on the second transaction -- amounting to a "net" loss of $6,200. This, amazingly, is the same amount of loss Larry computes when taking the wash sale and basis adjustment rules into account. So, since Larry closed out his entire position in the shares prior to the end of the year (and stayed out of the stock for the required 30-day period), the wash sale transactions actually become meaningless, and Larry can compute his gains and losses as he regularly would.

So, remember: the wash sale rules really only apply when the transactions bridge two tax years. You can trade all you want throughout the year, but if you close out your position prior to the end of the tax year and stay out for the required period of time, the wash sale issues are really not important. But, if you hold on to just one little share into the new tax year, you can look forward to making a bunch of wash sale computations.

One final note: while the wash sale provisions work on shares that you sell for a loss, there are no corresponding provisions for stock that you sell at a gain and then immediately repurchase. So, while wash sale losses can't be claimed, gains can't be avoided. That is, if you sell stock for a gain and buy it right back, you must still report the entire gain -- no special gain deferral rule applies.
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