The Wash Sale Rule
Investors and regular Traders in Securities are both subject to the wash sale rule. M2M Traders in Securities and Dealers are generally exempt from the Wash Sales Rules for those securities used in their business. This IRS rule (§1091 & §267) limits and defers the current deduction of losses in actively traded securities for the trader herself and her family if you buy and sell substantially the same security within a 61-day window (also referred to as being from “30 days before the sale until 30 days after the sale”).
This includes common & preferred stocks and put & call options on those stocks as well as other securities and debt instruments but excludes futures contracts and foreign currencies. Even if a stock is sold and bought on the same day, the wash sale can apply to that transaction. Short sales likewise are subject to the rule. Creative “games” like a wife selling her stock followed by a purchase by her husband or by a family controlled corporation, also result in a deferred (or disallowed) tax-loss. As you can imagine, this can be a real nightmare for active traders who concentrate in just a few different stocks.
Once a transaction’s loss is deferred because of the wash sale rule the basis of the stock currently acquired/held is adjusted upward by the amount of the deferral. The next transaction involving those shares, be it the next day or the next year, utilizes the new higher adjust tax-basis. Therefore, if the entire position is subsequently liquidated and you further remain out of the stock for the next 31 consecutive days, the entire deferred loss will generally be recognized for tax-purposes through the increase in basis used to compute the final gain or loss. But if you should re-enter the position within the 31 following days you may again find the wash sale rule comes into play. For active traders this can go on and on and on.
One unofficial “trick” to avoid some or all of the annual headache is to stop trading and holding any and all positions for a 31 consecutive day period that includes December 31st. If you do this at both the beginning and the end of any given calendar year, generally, you can just ignore the wash sale rule with relative impunity. (this isn’t really a “trick”, it’s just “in the math” of counting days pursuant to the rule)
As is usual in the tax law, there are numerous exceptions with this “trick”. If you do trade or hold a stock in either 31-day period (the one at the beginning of the year or the one at the end of the year) you will need to review that stock for the whole year to see how the wash sale effects you.
Even if you have no positions or activity at all during both 31-day periods (the one at the beginning of the year or the one at the end of the year) there are rare circumstances where the wash sale could still have some effect. For example, if (for some unrelated reason) you need to compute your income for only part of the year – then the wash sale, technically speaking, should not be ignored during the year. But if you are like most folks, this situation almost never comes up. For those who are curious – typically the need to compute your income for part of the year might arise due to death; divorce; marriage; other contractual issues; s-corp. issues; when trying to minimize or eliminate an estimated tax penalty by using the annualized income installment method; when new tax rate changes become effective in mid-year, and so on.
The good news is that Securities Traders properly electing mark-to-market under IRC §475 are not subject to the above wash sale rule on those securities covered by their mark-to-market election. i.e. any of their separate unrelated investment securities will continue to be subject to the wash sale rule.
Wash Sales and IRA’s
Based on discussions here at TraderStatus.com and at Fairmark.com, on December 20, 2007 the IRS issued an advance copy of Rev. Rul. 2008-5, 2008-3 I.R.B. ___ (1/22/08), (Rev. Rul. 2008-5 was then finalized on January 22, 2008) which applies the §1091 wash sale rules where a taxpayer sells stock or securities at a loss and then causes her IRA to purchase substantially identical stock or securities within thirty days. As a result, the loss on the sale is disallowed and the taxpayer’s basis in the IRA is not increased.
Excellent links that discuss the wash sale rule:
Some of these links include the opinions of their authors
(keep in mind that these links may not be updated and could get stale):
- Motley Fool, basic overview
- Fairmark Press, covers many angles
- BusinessWeek Investor 11/13/2000 story of wash sale strategy’s
- IRS broadens the definition of wash sale (The CPA Journal July 1, 1992 Willens, Robert)
- SEC Administrative Proceeding against Rajan Moondra
- SEC v. Kin H. Lee
- SEC definition of Wash Sales
- IRS publication 550, see chapter 4, pages 51 & 52 (pdf format)
- IRS Code §1091 “wash sales”
- IRS Code §267 “related party wash sales”
- Preserving Tax Losses by Avoiding the Wash-Sale Rules
- Rev. Rul. 2008-5
There are special rules for “§1256 Contracts” which are beyond this page’s discussion. §1256 includes: regulated futures contracts, foreign currency contracts, non-equity options, dealer equity options and dealer securities futures contracts. This are generally reported on IRS form 6781
A typical story from Wash-Sale Hell
I was an active day trader. At the end of the year, I had lost several thousand dollars. I’m currently being audited for that year and, because of the wash sale rule, the IRS wants to push my losses into 1997. Instead of a loss, they claim I had a capital gain of almost $250,000, creating a tax liability of more than $80,000. On top of this, they want to charge me almost $40,000 in interest, including interest for the 19 months it has taken for them to complete their review of my return!
This seems grossly unfair to me, and I am in the process of fighting their determination and would like to change the wash sale rules so that they don’t apply to active traders. If you have a horror story about trading and the IRS, please send me a message.
500.12 Stock sold to reduce holdings. The deduction of a loss sustained on the sale of a portion of the shares of stock or other securities purchased in one lot less than 30 days before the sale will not be disallowed merely because the sale is of a part of that lot. However, the deduction will be disallowed if the taxpayer, in another transaction occurring within the period beginning 30 days before the date of the sale and ending 30 days after such date, has acquired or has entered into a contract or option so to acquire, additional substantially identical stock or securities. §1.109–1. (Sec. 1091, ’86 Code.) Rev. Rul. 56-602, 1956-2 C.B. 527.