Wash sale

A wash sale is a sale of a security (stocks, bonds, options) at a loss and repurchase of the same or substantially identical security shortly before or after.[1]  Wash sale regulations protect against an investor who holds an unrealized loss and wishes to make it claimable as a tax deduction within the current tax year. The security is then repurchased in the hope that it will recover its previous value, which would only become taxable in some future tax year. A wash sale can take place at any time during the year. In the UK, a similar practice which specifically takes place at the end of a calendar year is known as bed and breakfasting. In a bed-and-breakfasting transaction, a position is sold on the last trading day of the year (typically late in the trading session) to establish a tax loss. The same position is then repurchased early on the first session of the new trading year, to restore the position (albeit at a lower cost basis). The term, therefore, derives its name from the late sale and early morning repurchase.[2]

In some tax codes, such as the USA and the UK, tax rules have been introduced to disallow the practice (e.g., if the stock is repurchased within 30 days of its sale). The disallowed loss is added to the basis of the newly acquired security.

Identification

In the USA wash sale laws are codified in "26 USC § 1091 - Loss from wash sales of stock or securities." The corresponding treasury regulations are given by CFR 1.1091-1 [3] and 1.1091-2.[4]

Under Section 1091, a wash sale occurs when a taxpayer sells or trades stock or securities at a loss, and within 30 days before or after the sale:[5][6]

  1. Buys substantially identical stock or securities,
  2. Acquires substantially identical stock or securities in a fully taxable trade,
  3. Acquires a contract or option to buy substantially identical stock or securities, or
  4. Acquires substantially identical stock for an individual retirement account (IRA).

The "substantially identical stock" acquired in any of these ways is called the "replacement stock" for that original position.

Consequences

In USA, the wash sale rule has the following consequences:

  1. The taxpayer is not allowed to claim the loss on the sale (the loss is not "realized").
  2. Basis Adjustment: The disallowed loss is added to the cost basis of the replacement stock.
  3. Holding Period: The holding period for the replacement stock includes the holding period of the stock sold.

Basis adjustment

After a sale is identified as a wash sale and if the replacement stock is bought within 30 days before or after the sale then the wash sale loss is added to the basis of the replacement stock. The basis adjustment is important as it preserves the benefit of the disallowed loss; the holder receives that benefit on a future sale of the replacement stock. However, if the replacement shares are in a tax-advantaged account, such as an IRA, the disallowed loss cannot be added to the basis and there is no benefit for the loss.[7]

The identification of a wash sale and adjusting the basis of the replacement stock is an iterative process. Thus, the sale of the replacement stock (after its basis is adjusted) can also be identified as a wash sale if it meets the above criteria.

Because of the basis adjustment in taxable accounts, the wash sale rule usually does not have a significant impact there. In most cases, it simply means the benefit will be reflected on a later report.

Holding period

When a wash sale occurs, the holding period for the replacement stock includes the period you held the stock sold.

Trading

Wash sales have implications for trading as well. Certain buyers are prohibited from purchasing stocks if they are trading too frequently, out of liquidity concerns. Wash sales drive up the volume of trading, making a share seem more liquid than it is.

References

  1. ↑ "Internal Revenue Code Sec. 1091".
  2. ↑ "What is bed and breakfast deal? definition and meaning". BusinessDictionary.com.
  3. ↑ "CFR 1.1091-1". Retrieved 1 April 2015.
  4. ↑ "CFR 1.1091-2". Retrieved 1 April 2015.
  5. ↑ "Investment Income and Expenses" (PDF). IRS Publication 550. 2011. p. 60. Retrieved 14 Sep 2012.
  6. ↑ Thomas, Kaye A. (April 8, 2011). "Wash Sales 101". Tax Guide for Investors. Fairmark Press Inc. Retrieved 14 Sep 2012.
  7. ↑ Thomas, Kaye A. (December 20, 2007). "Wash Sales and IRAs". Tax Guide for Investors. Fairmark Press Inc. Retrieved 22 May 2018.
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