Investment Losses and the Wash Sale Rule

Investment Losses and the Wash Sale RuleMost investors are familiar with the concept of “capital gains.” A capital gain is a profit that results from the sale of an asset that has appreciated beyond its purchase price. While capital gains are taxable, long-term capital gains (those from investments held more than a year) are taxed at a favorable rate as compared to ordinary income.

What about capital losses?

While nobody wants to lose money, there are some advantages to booking an investment loss. In fact, capital losses can be used to offset capital gains from other investments or, if you you don’t have any (or enough) gains to offset, they can be used to reduce your ordinary income. While you’re limited to offsetting $3k/year of ordinary income, you can carry your losses forward until they’re used up.

Tax loss harvesting

This ability to offset gains and/or income with losses makes possible a strategy known as “tax loss harvesting.” Suppose you’ve invested in a certain mutual fund, and the price has tanked. Assuming that this is an investment you want to hold for the long term, you might be inclined to sit tight.

Instead, you might opt to sell your shares to book the loss so you can take advantage of your bad luck at tax time. Now that you’ve locked in your loss, however, you don’t want to miss out on a possible rally, do you? So the next question is… How soon can you buy back in? This is where the “wash sale” rule comes in.

What is a wash sale?

The wash sale rule requires that an investor wait at least 31 days after selling a security for a loss before repurchasing the same security, or a “substantially identical” investment. If you buy back in within 30 days, the IRS will treat it as if you never sold in the first place, and you’ll lose the ability to claim a loss.

Oh, and before you try to get clever, keep in mind that the IRS will also treat it as a wash sale if you make your purchase within the 30 days before the sale of your downtrodden shares. Thus, you can’t simply buy shares ahead of the sale to avoid triggering a wash sale.

What is “substantially identical”?

Unfortunately, the IRS hasn’t defined exactly what “substantially identical” means. The general consensus seems to be that, for example, a mutual fund and its corresponding ETF from the same company are likely to be viewed as substantially identical.

On the other hand, two funds tracking different indices (e.g., S&P 500) are unlikely to trigger a wash sale. The intermediate case, in which funds from different companies that track the same index are exchanged, is less clear. Experts are split, and the IRS hasn’t provided any guidance, but I wouldn’t risk it.

As always, be sure to check with a professional tax advisor if you’re unsure, as the stakes are often quite high in these sorts of transactions.

5 Responses to “Investment Losses and the Wash Sale Rule”

  1. Anonymous

    One thing to watch out for regarding wash sales is if you have automatic dividend reinvestment. If you automatically bought some shares on april 1, then sold a bunch of the same shares on may 15 for a loss (even if they were shares you bought earlier), uh oh, wash sale!

    Also, if you do have a wash sale, the excluded amount is added to the basis of the shares you keep. But if the shares you bought were in a tax-advantaged account (e.g. an IRA) then basis is irrelevant. So this is a tricky way in which you can have the disallowed loss permanently lost! So one thing you should never do is sell stocks at a loss in a taxable account, to “transfer” the money into an IRA and buy the same position.

    I do wish the IRS would clarify if two index funds following the same index are “substantially identical” or not.

  2. Anonymous

    John – Losses on on the sale of a personal residence cannot be deducted. Gains on the sale of a principal residence are includable in income (subject to an exclusion for qualifying taxpayers of up to $250,000 for singles, $500,000 for married joint filers), but there’s no tax benefit if you sale your home at a loss. So if your girlfriend sells her house for a $30,000 loss, she won’t be able to deduct any of that loss. (The rules are complicated, but home improvements can in some circumstances be added to the cost of the house.)

  3. Anonymous

    Tyler: My understanding is that the losses can be carried over indefinitely. Each year, they are applied first to capital gains, and then up to $3k can be used to offset ordinary income.

    Here’s a snippet from IRS Tax Topic 409:

    “If your capital losses exceed your capital gains, the amount of the excess loss that can be claimed is the lesser of $3,000, ($1,500 if you are married filing separately) or your total net loss as shown on line 16 of the Form 1040 Schedule D, Capital Gains and Loses. If your net capital loss is more than this limit, you can carry the loss forward to later years.”

    There’s no mention of a limit on how long you can carry over such losses.

    The calculation is outlined in IRS Publication 550.

  4. Anonymous

    The loss on long-term stocks can be carried over year-to-year, with no expiration? My wife owns tech stocks that were purchased in 2000, so they have suffered severe losses. I’d like to cash out the stocks and get in on an S&P 500 index fund, but only if the losses can be carried over – I remember reading or hearing that two years was the maximum ($3k per year so $6k total) you could use losses for. Is that not the case?

  5. Anonymous

    Would this work the same if you sold a house for a loss? My gf owns a house and if we were to get married, she would move to where I live, but she would have to either sell the house at a substantial loss or rent it out most likely at a loss.

    Can improvements to the house be counted as part of the investment? If you spend 100k on a house, do 20k of renovations, then you have to sell in a weak market for 90k, can you take a 30k capital loss and spread it out over the next 10 years of income at 3k/year?

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