Capital gains taxes are well-known to significantly reduce long-term investment returns. Naturally, most investors want to minimize their tax bills. Sometimes, investors sell assets that have fallen below their purchase price, allowing them to claim a capital loss.
Definition of the Wash Sale Rule
Simply put, the wash sale rule prevents an investor from claiming a capital loss for tax purposes if they repurchase the same stock or security within 30 days.
Example
Imagine for a moment that an investor holds shares of Lucent Technology that he purchased when it was trading over $70 per share. Over the following years, before the company disappeared through mergers and acquisitions, the investor witnessed accounting scandals, financial troubles, and sales collapses causing the stock price to drop to $1.
The investor realizes that if he sells his shares, he can report a capital loss and reduce his tax burden. The problem is that he believes Lucent, or the company that ultimately owns it, will rise from the ashes and regain some of the market value it has lost.
Suddenly, the investor gets a brilliant idea. During the last week of December, he contacts his broker with instructions to sell his shares in the communications equipment provider, realizing a capital loss. Three weeks later, during the first half of January, he asks his broker to repurchase those shares from Lucent. Everything is right in the world; they secured the capital loss while keeping the shares. Sounds genius, right?
Legal Implications of the Wash Sale Rule
What happens if the IRS decides that the investor has violated the wash sale rule? The immediate result is that he will not be allowed to use the loss on his tax return for that year to offset taxable income.
However, he will be able to add the loss to the cost basis of the repurchased investment. The investor can also add the holding period of the original investment to the holding period of the replacement investment. This may allow him to claim larger losses in the future or qualify for lower capital gains rates.
How to Overcome the Rule
Can the investor wait until the wash sale period expires before repurchasing the stock? In fact, yes. As mentioned earlier, there are several problems with this approach. In addition to the double commissions, there is a very real risk that Lucent could rise in the short term, forcing the investor to buy it back at a much higher price than he intended.
The moral of the story? Sell only if you accept the fact that you may not be able to repurchase the stock in the future at the same price or lower. If you are prepared for that possibility, nothing is stopping you.
Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and keep our content accurate, reliable, and trustworthy.
Investor.gov. “Wash Sales.”
IRS. “Publication 550 (2019), Investment Income and Expenses.”
Nokia. “Nokia Finalizes Its Acquisition of Alcatel-Lucent, Ready to Seize Global Connectivity Opportunities.”
Charles Schwab. “A Primer on Wash Sales.”
Fidelity. “Wash Sale: Avoid This Tax Pitfall.”
Source: https://www.thebalancemoney.com/the-wash-sale-rule-356081
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