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 may 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. The 61-day period includes the sale date, the 30 days before the sale, and the 30 days after the sale. If you acquire fewer replacement shares than you sold, only the loss associated with the matched replacement shares may be disallowed. It applies to most of the investments you could hold in a typical brokerage account, 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 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.
Both ETFs and mutual funds can be particularly helpful in avoiding the wash-sale rule when selling a stock at a loss. Unlike some funds that focus on broad-market indexes, like the S&P 500®, others focus on a particular industry, sector, or other narrow group of stocks. These funds 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 another 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.
Good to know: Reinvested dividends via dividend reinvestment plans (DRIPs) may trigger a wash sale. If you sold the same security at a loss within 30 days, automatic repurchases through dividend reinvestments count as acquiring substantially identical securities, potentially disallowing all or part of the loss under the wash-sale rules. Your broker may not identify every wash sale, particularly when transactions occur in different accounts. You are responsible for reporting a wash sale even if it is not reported on Form 1099-B.
What happens if you have a wash sale?
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. If the replacement is purchased in an IRA or Roth IRA, IRS publication 550 confirms it is still a wash sale. But under Revenue Ruling 2008-5, the basis in the IRA is not increased. This means the disallowed loss is effectively forfeited, not deferred.
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. The wash-sale period covers 61 days: the 30 days before the sale, the sale date, and the 30 days after it. To avoid triggering a wash sale, check for purchases of the same or a substantially identical security during the 30 days before the sale, and wait until at least the 31st day after the sale before buying it again. For example, if you sell a stock on July 1, you should not repurchase it until August 1. And if you buy a stock on July 1, you should not sell that stock at a loss until August 1. You can also 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.
Watch this video to learn more about wash sale rules— one of many IRS trading rules—so you're ready when it's time to file your taxes.