What is the Wash-Sale Rule?
Define the Wash-Sale Rule In Simple Terms
A wash-sale is a tax strategy to sell and immediately repurchase stocks that have dropped in value in order to maintain ownership of the stock, but also claim a tax deduction for the loss on tax filings.
Unrealized vs Realized Capital Loss
To understand wash-sales, one must first understand the difference between unrealized and realized capital loss.
Unrealized capital losses are “floating”losses on stocks that have not been sold, so the loss has not actually been incurred.
Losses are “realized,”or permanently incurred, when the stock is sold. Only realized capital losses are tax deductible—this is where the wash-sale rule comes into play.
To reduce tax liability, some investors may attempt to sell the stock of an unrealized loss in order to incur a realized loss, but then immediately buy the stock back to maintain their ownership in the company. This is called a “wash-sale.”
To prevent these kinds of tax-deductions, the IRS instituted the Wash-Sale Rule.
The Wash-Sale Rule prohibits claiming losses on tax filings if the same or “substantially identical”investment is purchased within 30 days before or after the sale.
To avoid the Wash-Sale Rule, investors can either:
- Wait until the 30-day period has passed, which runs the risk of missing out on a stock’s appreciation during that period,
- Or utilize tax loss harvesting which sells one stock to offset the gains of another stock and invest in a similar, but not “substantially identical,”investment. These could be industry focused ETFs, mutual funds or competitors
Because profits earned from investments held for more than 1 year are categorized as long-term capital gains and are taxed at a lower tax rate than short-term capital gain, it’s important to note that selling and rebuying a stock resets the purchase date and may increase tax liability.