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Mind the Wash Sale Rule When Harvesting Tax Loans
While stock values have mostly gone up so far this year, bull markets don't last forever. And the price of a particular stock can fluctuate up or down, independent from the market's overall trend line.
When you make what turns out to be an ill-fated stock investment in a taxable investment account, the saving grace is you can usually claim a tax-saving capital loss deduction (within limits) when you sell. But that's not always the case: The wash sale rule can disallow your tax savings. Here's how the dreaded wash sale rule works.
A loss from selling stock or mutual fund shares is disallowed for federal income tax purposes if you buy substantially identical securities within the 61-day period that begins 30 days before the date of the loss sale and ends 30 days after that date. The theory is that the loss sale and the offsetting purchase of substantially identical securities within the 61-day period amount to an economic "wash." Therefore, you're not entitled to any loss deduction, and the tax savings that would ordinarily result from the loss sale are disallowed.
When you have a disallowed wash sale loss, the loss doesn't just vaporize, except when your IRA or controlled corporation acquires the substantially identical securities (explained below). Instead, the general rule is that the disallowed loss is added to the tax basis of the substantially identical securities that triggered the wash sale rule. Then, when you eventually sell those substantially identical securities, the extra basis reduces your tax gain or increases your tax loss.
In effect, the disallowed loss becomes a deferred loss that's accounted for when you sell the substantially identical securities.
To help you understand how the wash sale works, suppose you bought 1,000 Beta Bank shares on July 1, 2021, for $20,000 using your taxable account at a brokerage firm. The value of the stock plummets. You thought you could harvest a tax-saving $8,000 capital loss by selling the shares on December 15, 2021, for $12,000 ($20,000 basis minus $12,000 sales proceeds equals $8,000 loss). You plan to use that loss to shelter an equal amount of 2021 capital gains.
After you thought you had secured the tax-saving loss, you then reacquire 1,000 Beta shares on December 19, 2021, for $12,200, because you still like the stock. Sadly, the wash sale rule disallows your anticipated $8,000 capital loss deduction.
Instead, the disallowed loss increases the tax basis of the substantially identical securities. Therefore, the tax basis of the Beta shares you acquire on December 19, 2021, increases to $20,200 ($12,200 cost plus $8,000 disallowed wash sale loss).
Two Ways to Beat the Rule
Avoiding the wash sale rule is only an issue when you want to sell a stock or security to harvest a tax-saving capital loss, but you still want to own the stock or security because you think it will appreciate from the current price.
One way to defeat the wash sale rule is with a "double up" strategy. You buy the same number of shares in the stock you want to sell for a loss. Then you wait 31 days to sell the original batch of shares. When all is said and done, you've made your tax-saving loss sale, but you still own the same number of shares as before and can therefore still benefit from the anticipated appreciation.
For example, you want to sell the 1,000 Zeta shares that you currently own for a 2021 tax-saving loss. But you don't want to give up on the stock. So, on November 21, you buy 1,000 more Zeta shares. Then you can sell the original batch of 1,000 shares for your tax-saving loss anytime between December 22 and December 31. The wash sale rule is avoided because December 22 is more than 30 days after November 21.
You can achieve the same goal with a less expensive alternative approach: Buy a cheap call option on the stock you want to sell for a 2021 tax loss. Then wait more than 30 days to sell the stock.
For example, you currently own 1,000 Yazoo shares that you want to sell before year end to harvest a tax-saving 2021 capital loss. But you don't want to give up on the stock. It might only cost $100 to buy a January 2022 call option for 1,000 Yazoo shares, while buying 1,000 actual shares might cost $10,000 or more. Say you buy a call option for 1,000 shares on November 21. You can sell your 1,000 Yazoo shares that you currently own anytime between December 22 and December 31 and claim a tax-saving capital loss on your 2021 return, because you successfully avoided the wash sale rule. Make sure to wait at least 31 days before selling the Yazoo shares, because the call option and the stock are considered substantially identical securities for purposes of the wash sale rule.
Important: To use either of these strategies, you must act on or before November 30, 2021, to have enough time to make a 2021 loss sale without triggering the wash sale rule.
No Creative Workarounds
Some people have tried to come up with creative workarounds for the wash sale rules by purchasing substantially identical securities through an IRA or an account owned by a related party. But the IRS won't fall for these tricks.
According to the IRS, using a traditional or Roth IRA to buy substantially identical securities within 30 days before or after a loss sale in your taxable brokerage account will trigger the wash sale rule. Even worse, the IRS says you can't increase the tax basis of your IRA by the disallowed loss. The disallowed loss simply disappears.
What happens if you sell stock for a loss, and then your spouse buys identical stock within the forbidden 61-day period? The wash sale rule would clearly apply if you file your tax return jointly. And the IRS has issued guidance that says the wa
sh sale rule applies even if you and your spouse file separate returns. The IRS also says the wash sale rule applies if a corporation that you control purchases substantially identical securities.
Seek Professional Advice
If you're hoping to harvest a tax-saving capital loss before year end and you have questions, please contact us. We can discuss ways to reduce your taxes and reposition your portfolio.
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