Most investors understand that if you sell a stock, mutual fund or security for less than what you paid for it, you can claim a loss on your tax return that can be used to offset capital gains on your other investments. Actively managing your portfolio to recognize losses that can offset your gains is an excellent way to lower your total taxes – provided you understand and comply with the “wash sale” rules.
The IRS does not allow you to claim a loss from the sale of a stock or security if you repurchase the same or “substantially identical” stock or security within 30 days, either before or after the sale. This is called a wash sale, and the loss cannot be recognized immediately. Instead, the loss is added to the cost basis for the new purchase.
Let’s look at an example. Let’s say that Megan, a fellow investor, originally purchases 100 shares of ABC stock at $10 per share, or $1,000 total. On July 1, ABC stock is selling at $7 per share. Megan decides to sell her 100 shares for $700 total. She has a loss of $300. But on July 10, ABC stock drops to $5 per share. Megan decides this is an excellent buying opportunity, so she re-purchases 100 shares of ABC stock at the lower price. This series of trades has created a wash sale, and Megan can no longer claim the $300 loss on the original purchase and sale, at least not at this time. The disallowed $300 loss is applied to the re-purchase price (or basis). So the basis of Megan’s second purchase is $800 – the $500 purchase price plus the $300 disallowed loss from the initial purchase. The benefit of the initial loss is deferred until the new replacement shares are sold.
But what if Megan wants to claim the tax loss? She could wait until August 1 or later before re-purchasing any ABC stock. If she doesn’t want to be out of the market for an entire month, she could identify and purchase another similar (but not “substantially identical”) stock. For example, XYZ stock may be in the same industry, but since it is a different company, it is not “substantially identical” and the wash sale rules wouldn’t apply to the purchase of XYZ stock.
So, what is the definition of a “substantially identical” security? While the strict definition can get complex and is subject to interpretation, it’s easier to look at the bigger picture. Is it an identical investment? Stocks in different companies in the same industry are not identical. Stock in Apple is not identical to stock in Microsoft. However, different classes of stock in the same company are likely to be considered “substantially identical.”
For mutual fund investors, a Large Cap Growth Fund from one mutual fund provider is not identical to a Large Cap Growth Fund from another mutual fund provider. There are almost certainly significant differences in their holdings. However, an S&P 500 Index fund from one mutual fund provider is likely to be “substantially identical” to an S&P 500 Index fund from another mutual fund provider, because, by definition, their holdings are the same.
Another point to keep in mind: crossing over to a new year has no impact on the wash sale rules. You can’t sell a stock at a loss on December 20 and re-purchase the stock on January 10 and recognize the loss. That is still a wash sale. You still need to wait at least 30 days before repurchasing if you want to claim the loss.
Also, investors that participate in automatic purchase plans, such as monthly mutual fund purchases or purchases of company stock, or even reinvestment of dividends should be cautious of purchase and resale dates to avoid triggering a wash sale, particularly when temporarily selling your entire position.
Periodically harvesting losses in your portfolio is an excellent way to minimize your overall tax bill. Just watch your calendar and re-purchases after selling for losses. With just a bit of thought, it’s not difficult to avoid a wash sale.
Gene Salo is Senior Director at TaxSimple.com, an online do-it-yourself tax preparation program designed to make filing your personal income taxes easy and convenient.