Wash Sales

Wash sales refer to a type of transaction in the stock market where an investor sells a security at a loss and then purchases a substantially identical security within 30 days before or after the sale. This type of transaction is prohibited by the Internal Revenue Service (IRS) as it is seen as an attempt to create a tax benefit by realizing a loss without actually changing the investor’s economic position. In this article, we will explore wash sales in detail and provide guidance on how to avoid them.

What is a Wash Sale?

As mentioned earlier, a wash sale occurs when an investor sells a security at a loss and then buys a substantially identical security within 30 days before or after the sale. The 30-day period is not limited to calendar months, so an investor needs to be careful when considering purchases or sales of similar securities.

For example, let’s say an investor bought 100 shares of XYZ stock for $50 per share. The value of the stock then drops to $40 per share, and the investor sells the 100 shares, realizing a $1,000 loss. However, within 30 days of the sale, the investor buys 100 shares of the same stock for $45 per share. In this case, the sale is considered a wash sale because the investor bought a substantially identical security within 30 days of the sale.

The tax consequences of a wash sale are that the loss is disallowed for tax purposes, and the investor’s cost basis in the new security is adjusted to reflect the disallowed loss. This means that the investor cannot deduct the loss on their tax return, and their cost basis in the new security is increased by the amount of the disallowed loss. As a result, the investor’s future capital gains on the new security will be reduced, and they may end up paying more taxes than if they had not engaged in a wash sale.

How to Avoid Wash Sales

The best way to avoid wash sales is to wait for at least 31 days after the sale before buying a substantially identical security. This waiting period ensures that the sale is no longer considered a wash sale, and the investor can deduct the loss on their tax return.

However, waiting for 31 days may not always be practical or desirable. For example, if an investor believes that a particular stock is undervalued and wants to take advantage of the price drop, they may want to buy the stock right away, even if they sold a similar stock at a loss in the previous 30 days.

In this case, the investor can consider one of several alternatives to avoid a wash sale. One option is to buy a similar but not substantially identical security. For example, if an investor sold shares of a particular company’s common stock at a loss, they could consider buying shares of the company’s preferred stock or a different class of common stock.

Another option is to wait for more than 30 days but still maintain exposure to the same industry or sector. For example, if an investor sold shares of a technology company’s stock at a loss, they could wait for more than 30 days and then buy shares of another technology company in the same industry.

Finally, an investor can consider using options to maintain exposure to the same security without triggering a wash sale. For example, if an investor sold shares of a particular stock at a loss, they could consider buying a call option on the stock instead of the stock itself. This would allow them to maintain exposure to the stock while avoiding a wash sale.