The “Wash Rule” in Investing and How it Applies to You

What is the Wash Sale Rule? This is an infrequently asked question, but an important one nonetheless (especially this year while investors are likely sitting on large capital losses) since traders violate it somewhat routinely without even being aware of the rule – and if challenged by the SEC, they could face some pesky consequences.  At a high level, a wash sale occurs when an investor sells shares of a security at a loss and buys them back soon thereafter.  The motive is the assumption that shares perhaps took a precipitous dive and will rebound quickly, coupled with the notion that the investor can take a significant tax loss in the current year, then buy back the shares and hang on as long as desired, deferring that capital gain into the foreseeable future. In the US, IRS tax rules mandate that shares cannot be repurchased until 30 days have elapsed since the initial sale.  A wash sale is generally viewed as a way to artificially derive a tax benefit or “cheat the system” if you will.

Wash Rule Example?

Here’s an example.  You bought a previously high-flying Financial stock in early 2008 – take your pick – “X” we’ll call it.  According to the relevant IRS publication 550 (page 55), the following example was cited:

You buy 100 shares of X stock for $1,000. You sell these shares for $750 and within 30 days from the sale you buy 100 shares of the same stock for $800. Because you bought substantially identical stock, you cannot deduct your loss of $250 on the sale. However, you add the disallowed loss of $250 to the cost of the new stock, $800, to obtain your basis in the new stock, which is $1,050.

It’s a case of – you’re going to pay the taxes now or later – but under wash sale rules, you don’t get the benefit of an early tax deduction.

Can you get around the Wash Sale Rule Legally?

Sort of – I’m not certified to give out tax or investing advice, so check with your own certified professional – but based on the research I’ve encountered, if there are alternatives to the stock you just sold that are not viewed as “substantially identical” by the IRS, then you could in effect, sell the one poor performing asset and lock in your tax loss in the current year, and then buy back something that “perhaps” will perform similarly moving forward, but is not viewed as “substantially identical”.  The wash sale rules apply to purchasing a stock option to attempt to work around the rule for a particular stock as well.

According to the IRS,

“ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation…”

Unfortunately, the IRS does not cite precedent for ETFs.  If for instance, you had sold an S&P500 ETF at a significant loss and decided to buy back say, the Nasdaq ETF QQQQ immediately thereafter, I can only assume that they could not be considered to be “substantially identical” – especially since they’re not comprised of the exact same stocks (some overlap but some don’t appear in both indices).  However, it gets a little trickier for say, swapping one Biotech ETF for another.  While the ratios of particular stocks may differ, the concept of the ETF (biotech stocks) and probably the vast majority of the companies (or at least the top holdings) may be similar.

Again, if you stand to gain from enacting a wash rule-type transaction and want to do so legally, check with your tax adviser or investment adviser, but consider asking about legal ways to execute your strategy like the example I cited above.

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