A Beginner’s Guide to Wash Sales

Are you prepared for large liabilities?

*Not professional tax advice. Please consult a tax attorney and accountant prior to making any investment.

A wash sale occurs when you sell a security at a loss, and then buy the same or a substantially identical security within 30 days before or after the sale. The IRS does not allow immediate recognition of the loss for tax purposes and instead, the loss is added to the cost basis of the new investment.

Now let’s put this in a practical context.

Say, for example, you purchased 100 shares of XYZ Corp for $10 per share, so your total investment was $1,000. Unfortunately, the market turns against you and the price per share drops to $7. Feeling discouraged, you decide to sell your shares, realizing a loss of $300 ($1,000 initial investment – $700 from selling your shares).

At this point, you might normally be able to deduct this $300 loss from your taxable income, potentially saving you a bit of money when tax time rolls around. However, XYZ Corp presents a promising earnings report a week later, and feeling optimistic, you decide to buy back the 100 shares, this time for $8 per share.

Because you repurchased the same security within 30 days of selling it, the IRS considers this a wash sale. This means you cannot claim the $300 loss on your taxes immediately. Instead, the $300 loss is added to the cost of your new investment. So, the cost basis of your new shares in XYZ Corp is $1,100 ($800 actual cost + $300 deferred loss).

Now, let’s say later in the year you sell your XYZ Corp shares again for $1,200, realizing a gain of $100 ($1,200 selling price – $1,100 cost basis). For tax purposes, you will have to pay taxes on this $100 gain, even though from an economic perspective, you’re still $200 in the hole from your original investment ($1,200 final value – $1,000 initial investment – $300 additional investment). The IRS does not let you claim the $300 loss until you completely exit the position (and do not re-enter for 30 days). This could result in a larger tax bill than you expected, as your losses have been deferred while your gains are taxed immediately.

In essence, repeated wash sales without a 30+ day gap sometime during the year can defer your losses into future tax years, which could create a significant tax liability. It’s important to be aware of this rule when executing trades frequently in the same security. If you’re not careful, you could end up with a tax bill that far exceeds your actual economic gain.

Please remember this is a simplified example and tax laws can be complex and have many nuances, so always consult with a tax professional for advice specific to your situation.