The wash sale rule basically states that if you sell a stock at a loss and buy replacement stock 30-days before, or 30- days after the sale of the same stock, you canât deduct the loss. This rule does not apply to gains but only to losses. Naturally, the IRS wants to tax all of your gains. The best way to show the impact of the wash sale rule is through the following example:
On October 20, 2002 you purchase 1000 shares of Microsoft at $35 a share. On December 15, 2002 you sell the 1000 shares in Microsoft at $15 a share and recognize a 20,000 loss. On January 5, 2003 you buy back 1000 shares of Microsoft at $15 a share. Unfortunately, because of the wash sale rules, that $20,000 loss that the taxpayer thought they recognized in 2002 is disallowed.
If you wind up with a wash sale, add your disallowed loss to the basis of your replacement security. Your new basis is the purchase price of the replacement, plus the loss you couldn't take, plus fees related to the securityâs purchase. This means that your loss is postponed; itâs not gone forever. In the above example the taxpayers basis in the Microsoft stock he repurchase on January 5, 2003 would be $35 a share and not the $15 a share he purchased it at.
The definition of replacement stock is not obvious either. The IRS says it canât be âsubstantially identicalâ to the security you sold. Itâs easier to differentiate stocks than it is mutual funds, as no stock is substantially identical to another, even within the same industry. After all, each company differs from others in numerous ways.
When you sell the replacement security at a profit later, your basis will be higher, so your gain will lower. The end result? Less tax on a smaller gain. If you sell lower than your replacement security basis, your loss will be larger than it would be if based on the repurchase price alone, so you do get some recovery. All is not lost.
In your above example if you bought and sold Microsoft at a loss in June and July and did not buy back the stock within the 61 day period than the wash sale rule would not apply.
When you make a wash sale, your holding period for the replacement stock includes the period you held the stock you sold. This rule prevents you from converting a long-term loss into a short-term loss.
There are three ways to avoid the wash sale rule all together. The first way is to not buy back the stock or option within the 61 day period (30 days prior to the sale or 30 days after the sale). Another way to avoid having to deal with the wash sale rule is to elect the Mark-to-Market method of accounting. Of course this accounting election is only available to the active trader and not to someone who is an investor. Finally, the last way to avoid the wash sale rule is to trade in Futures, commodities, index options or forex. This type of trading falls under the rules of IRC 1256 and they have some fantastic tax benefits associated with them.
, by not trading stocks in December. I only trade futures, which do not have this particular tax problem.