You may have seller's remorse in a down market. Or you may be trying to capture some losses without losing a great investment. However it happens, when you sell an investment at a loss, it's important to avoid replacing it with a "substantially identical" investment 30 days before or 30 days after the sale date. It's called the wash-sale rule and running afoul of it can lead to an unexpected tax bill.
What is the wash-sale rule?
When you sell an investment that has lost money in a taxable account, you can get a tax benefit. The wash-sale rule keeps investors from selling at a loss, buying the same (or "substantially identical") investment back within a 61-day window, and claiming the tax benefit. It applies to most of the investments you could hold in a typical brokerage account or IRA, including stocks, bonds, mutual funds, exchange-traded funds (ETFs), and options.
More specifically, the wash-sale rule states that the tax loss will be disallowed if you buy the same security, a contract or option to buy the security, or a "substantially identical" security, within 30 days before or after the date you sold the loss-generating investment (it's a 61-day window).
It's important to note that you cannot get around the wash-sale rule by selling an investment at a loss in a taxable account, and then buying it back in a tax-advantaged account. Also, the IRS has stated it believes a stock sold by one spouse at a loss and purchased within the restricted time period by the other spouse is a wash sale. Check with your tax advisor regarding your personal situation.
How to avoid a wash sale
One way to avoid a wash sale on an individual stock, while still maintaining your exposure to the industry of the stock you sold at a loss, would be to consider substituting a mutual fund or an exchange-traded fund (ETF) that targets the same industry.
ETFs can be particularly helpful in avoiding the wash-sale rule when selling a stock at a loss. Unlike the ETFs that focus on broad-market indexes, like the S&P 500, some ETFs focus on a particular industry, sector, or other narrow group of stocks. These ETFs can provide a handy way to regain exposure to the industry or sector of a stock you sold, but they generally hold enough securities that they pass the test of being not substantially identical to any individual stock.
Swapping an ETF for another ETF, or a mutual fund for a mutual fund, or even an ETF for a mutual fund, can be a bit more tricky due to the substantially identical security rule. There are no clear guidelines on what constitutes a substantially identical security. The IRS determines if your transactions violate the wash-sale rule. If that does happen, you may end up paying more taxes for the year than you anticipated. So when in doubt, consult with a tax professional.
What is the wash-sale penalty?
If the IRS determines that your transaction was a wash sale, what happens?
You can't use the loss on the sale to offset gains or reduce taxable income. But, your loss is added to the cost basis of the new investment. The holding period of the investment you sold is also added to the holding period of the new investment. In the long run, there may be an upside to a higher cost basis—you may be able to realize a bigger loss when you sell your new investment or, if it goes up and you sell, you may owe less on the gain. The longer holding period may help you qualify for the long-term capital gains tax rate rather than the higher short-term rate.
That can be the silver lining—but in the short term you won't be able to use the loss to offset a realized gain or reduce your taxable income. Getting a letter from the IRS saying a loss is disallowed is never good so it's best to err on the side of caution. If you're concerned about a buying a potential replacement investment, consider waiting until 30 days have passed since the sale date. Or work with a financial professional who should be able to confidently navigate the ins and outs of taxes and your investments.
For more information, see IRS publication 550.