The Wash Sale Rule: Taxes & Your Portfolio
The end of the year is a good time to conduct a portfolio review to see what kind of impact movements in the market have had on your holdings and what adjustments might be made to keep your investments on track. Such a review can also be used to decide which, if any, securities might be sold in order to establish a tax loss which can be used to offset capital gains. However, when considering this year-end strategy, it's important to keep in mind the "wash sale" rule.
What is the Wash Sale Rule?
Simply put, if within 30 days before or after the sale of a security, you purchase a "substantially identical" security, the IRS will consider the sale a "wash" and disallow your tax loss. The disallowed loss will be added to the basis of the "substantially identical" stock or securities purchased, and the holding period of the original property is added to the holding period of the newly acquired property.
"Substantially identical" means different things for different investments. Here is a quick run down:
Stocks
Obviously, the common shares of one company are not "substantially identical" to the common shares of another company. Taxpayers will generally run afoul of the wash sale rule when they sell stocks at a loss and then repurchase the same stock, or an option to acquire that stock, within 30 days (excluding the date of the sale and the date of the requisition).
If you want to maintain a position in a particular stock and recognize the unrealized loss in that position you have two options:
1. Doubling up. If you don't want to be out of the market with respect to a particular stock, then you must increase your position in that stock by purchasing a similar block You can sell the original loss position 31 days later. Identify the specific lot you are selling. You can do this by noting "versus purchase" (VSP) and the date of the purchase on the lot on which you are recognizing the loss.
2. Repurchasing after 31 days. If you do not want the added risk involved with double exposure, then the only alternative is to dispose of the current long position at a loss and repurchase the stock, or an option to acquire the stock 31 days later.
Mutual Funds & The Wash Sale Rule
Mutual fund sales are subject to the wash sale rule. Like stocks, a taxpayer may not repurchase the fund sold within the 31-day window. You must be very careful when dealing with partial sale (loss) of mutual funds. Keep in mind that the reinvestment in dividends and capitol gains is considered an acquisition. Thus, there should be no reinvestment during the 30-day period leading up to the sale, nor should there be any reinvestments 30 days after the sale date.
Bonds
Bonds are not considered "substantially identical" if (1) the securities have different issuers or (2) there are substantial differences in either maturity or coupon rate, and preferably in both. Year-end "bond-swaps" are common planning techniques. You should be careful when repurchasing bonds from the same issuer. The differences in maturity and/or coupon rate should be different enough to change your position relative to the market.
Individual Retirement Accounts
"Can a tax payer sell stock at a loss in his or her personal account and repurchase the stock in an IRA?" This question was posed to the IRS and its response is as follows: "The wash sale rule doe snot apply when an individual sells securities at a loss and identical securities are purchased by his/her IRA within 30 days. The wash sale rules apply when the identical securities are purchased by the individual, his/her spouse, or a corporation the he/she controls." You should be aware that many practitioners caution against the use of this strategy. They argue that while this may not violate the wash sale rule, it could still be considered an indirect related party sale and the losses could nonetheless be disallowed.
Sources
1. Internal Revenue Code, Section 1091
2. Internal Revenue Service, Publication 550, page 52
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