Many investors, both individuals and professionals alike, have certain tendencies. One of these tendencies is to trade in and out of the same set of securities, often because of the investor's familiarity with those securities and perceived improved sense of their value. A second tendency is to "sell low", which is the opposite of what many advisors may encourage you to do but is what so many investors do, including at the bottom of the recent stock market crashes. A third tendency is to "tax-loss" harvest, which is the practice of selling a sufficient amount of securities, held in a taxable account, to offset your capital gains and have $3,000 of additional capital losses, which is the maximum amount that you can deduct against your earned income in most circumstances.
Whatever the reason for selling, the Internal Revenue Service does not want you to recognize a tax benefit (the capital loss) when you sell a security at a loss but then repurchase it within a short period of time. The wash sale rules begin with 26 U.S.C. 1091, and state that if a security is sold at a loss and then purchased (or a substantially identical security) within thirty (30) days before or after the date of the sale, then the loss on the initial sale (the "Wash Sale Security") is disallowed until that repurchased security (the "Replacement Security") is sold in a situation that does not also qualify as a wash sale. If the Replacement Security is not sold until the next tax year, then the wash sale rules prohibit a taxpayer from reporting the loss on the Wash Sale Security. Instead, that loss is added to the basis of the Replacement Security, so once it is sold (other than in a wash sale), the tax effect remains the same.
Oftentimes, an investor desires to sell a security at a loss to capture that loss, but does not want to wait 31 days to repurchase it. Unfortunately, if the investor purchases the Replacement Security inside of an IRA, or has his or her spouse purchase the Replacement Security, then the wash sale rules still apply. The wash sale rules apply to stocks, bonds, exchange traded funds, mutual funds and options. Selling a stock at a loss and then purchasing a call option on that same stock within the 61 day period (30 days on either side of the wash sale) violates the wash sale rules. In addition, selling one exchange traded fund that tracks the S&P 500 at a loss and purchasing a different exchange traded fund that also tracks the S&P 500 within the 61 day period violates the wash sale rules.
In short, if you or your advisor make multiple sales and purchases of the same security, make sure that you are comfortable with the wash sale rules or else consult a tax advisor that is comfortable with properly recognizing and reporting wash sales.
This blog is not intended to create an attorney/client relationship or provide legal advice. Please contact the author if you have any questions or comments regarding the subject matter.