Why the IRS Law is Important to Short-term Traders
The Wash Sale Rule prevents taxpayers from deducting losses on some investments that are repurchased. When does it apply and what are the reasons behind the rule?
The Internal Revenue Service is the governing body with respect to United States tax laws. The IRS allows many legitimate deductions from income, but as investors have developed ways to take advantage of the rules for inappropriate benefit, the IRS has issued regulations to enforce the spirit of the laws.
One of the legitimate deductions is allowing a taxpayer to deduct losses on investments, up to a current annual maximum of $3,000 for a single taxpayer.
The law also allows losses on investments to be used to offset gains. The wash sale rule was instituted to make sure this is not abused. Losses cannot be deducted from sales or trades of stock or securities in a wash sale.
When an investor sells or trades stock or securities at a loss and within 30 days before or after the sale they:
For example, an investor might have a $5,000 in realized gains (based on sales that have already occurred), and have an open position in XYZ stock that is sitting at a $5,000 loss. With no additional transactions, the investor would owe taxes on the $5,000 in realized gains.
The investor could sell the open position and realize the $5,000 loss, netting his taxable gain to zero. However, the investor may believe that XYZ stock will recover and does not want to give up his position.
If he buys back the stock within 30 days, even after the year has ended, he cannot deduct the loss, and will still have to pay taxes on the $5,000 realized gain.
To be clear, the law does not prevent him from selling or buying back the stock, but does not allow the deduction. The IRS only prevents the deduction of sham losses, which it defines as buying back in investment in 30 days.
In order to fully comply with tax law and still minimize taxes:
One of the legitimate deductions is allowing a taxpayer to deduct losses on investments, up to a current annual maximum of $3,000 for a single taxpayer.
The law also allows losses on investments to be used to offset gains. The wash sale rule was instituted to make sure this is not abused. Losses cannot be deducted from sales or trades of stock or securities in a wash sale.
IRS Definition of Wash Sales
IRS Publication 550 defines a wash sale as:When an investor sells or trades stock or securities at a loss and within 30 days before or after the sale they:
- Buy substantially identical stock or securities,
- Acquire substantially identical stock or securities in a fully taxable trade, or
- Acquire a contract or option to buy substantially identical stock or securities.
The Importance of the Wash Sale Rule
Because the IRS allows taxpayers to deduct losses against gains, the IRS issued the rule to prevent traders from taking sham losses in order to reduce taxes on gains.For example, an investor might have a $5,000 in realized gains (based on sales that have already occurred), and have an open position in XYZ stock that is sitting at a $5,000 loss. With no additional transactions, the investor would owe taxes on the $5,000 in realized gains.
The investor could sell the open position and realize the $5,000 loss, netting his taxable gain to zero. However, the investor may believe that XYZ stock will recover and does not want to give up his position.
If he buys back the stock within 30 days, even after the year has ended, he cannot deduct the loss, and will still have to pay taxes on the $5,000 realized gain.
To be clear, the law does not prevent him from selling or buying back the stock, but does not allow the deduction. The IRS only prevents the deduction of sham losses, which it defines as buying back in investment in 30 days.
Strategies Regarding Wash Sales
Wash sales can occur any time of year, but are most significant near and just after the end of a tax year. The law is based on facts, it does not matter what the intent of the trader is.In order to fully comply with tax law and still minimize taxes:
- Consider selling an investment and buying back more than 30 days after the sale. The rule is hard and fast, anything over 30 days does not count as a wash sale, whatever the intent.
- After selling, buy an investment which may be similar in nature but not substantially identical to the investment sold during the 30 days period. Retail giants Walmart and Target may be similar, but their stocks are anything but identical.
- Remember, at best tax loss selling is a delaying strategy. The decision to delay recognition of taxable income should take into account the taxpayer’s entire situation.
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