Watch Out for the Wash Sale Rule When Harvesting Losses

With the end of the year upon us, many investors are looking for opportunities to reduce tax liabilities by harvesting losses. As you’re considering selling assets, however, one important regulation to keep in mind is the Wash Sale Rule, in which the IRS can disallow a tax deduction for a security.

A wash sale occurs when an investor sells or trades a stock or securities at a loss and does any of the following within 30 days before or after the sale:

  • Buys substantially identical stocks or securities
  • Acquires substantially identical securities in a taxable trade, or
  • Acquires a contract or option to buy substantially identical securities.1

The rule is in place to prevent investors from claiming “artificial” losses. Essentially, to harvest losses from a sale, the investor has a “black-out period” of 30 days preceding and 30 days following the sale of the asset, for a total black-out period of 61 days. This rule also applies if one investor sells the security and then his or her spouse or company purchases a substantially identical security.2

On the flip side of this rule, if an investor realizes a gain on a sale and purchases a substantially identical stock within the black-out period, proceeds from the gain are still taxable.3 Also, the rule does not apply if the loss was incurred in your ordinary course of business as a dealer in stock or securities.4

To be considered “substantially identical,” the repurchased stock or security must be like-to-like. For example, if Joe Smith sells his 100 shares of Widget Company common stock on December 1 and purchases 100 shares of Widget Co. common stock on December 15, the transactions would fall under the wash sale rule. However, if Joe purchases common stock of a different company, that would not be considered substantially identical, even if he bought the same type of security.

Bonds and preferred stock are not typically considered substantially identical to a company’s common stock. In our example above, if Joe sells his Widget Co. common stock and purchases preferred stock, the transactions would fall outside the Wash Sale Rule. However, there are cases when preferred stock is considered substantially identical to the common stock. This happens when the preferred stock:

  • Is convertible into common stock;
  • Has the same voting rights as the common stock;
  • Is subject to the same dividend restrictions;
  • Trades at prices that do not vary significantly from the conversion ratio; and
  • Is unrestricted as to convertibility.5

For warrants, the rule applies if you realize a loss on the sale of common stock and replace it with warrants. However, if you sell warrants and replace with common stock, the rule only applies if the warrants and stock are considered substantially identical. The rule does not apply to sales or trades of commodity futures contracts or foreign currencies.6

If the IRS disallows the loss, the loss is added to the new stock and the total becomes the cost basis for the new stock. The loss is positioned until the new stock or securities are sold.7

Also, if you bought more or fewer shares than you sold, the Wash Sale Rule applies only to the matching number of shares. Going back to our earlier example, let’s say Joe sold 100 shares of Widget Co. common stock at a loss on December 1 and purchased 75 shares of Widget Co. common stock on December 15. He can deduct the loss on 25 shares. The disallowed amount from the additional 75 shares will be added to the cost of the new shares and will become its new cost basis.

 

1 U.S. Securities & Exchange Commission. “Wash Sales.” https://www.sec.gov/answers/wash.htm  Accessed Nov. 21, 2018.
2 Investopedia. “Wash-Sale Rule.” https://www.investopedia.com/terms/w/washsalerule.asp Accessed Nov. 21, 2018.
3 IRS. Apr. 12, 2018. “Publication 550 (2017), Investment Income and Expenses.” https://www.irs.gov/publications/p550#en_US_2017_publink100010601 Accessed Nov. 21, 2018.
4 Ibid
5 Ibid
6 Ibid
7 Investopedia. “Wash-Sale Rule.” https://www.investopedia.com/terms/w/washsalerule.asp Accessed Nov. 21, 2018.

 

This content is designed to provide general information on the subjects covered. It is not intended to provide specific legal or tax advice and cannot be used to avoid tax penalties or to promote, market or recommend any tax plan or arrangement. All individuals should be encouraged to consult with a tax advisor regarding their specific needs and individual circumstances.

676050 – For Investment Professional Use Only.

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