Wash Sale Rule

The IRS and Congress have designed the US tax code to be as fair as possible. The goal is to tax people when they have the means to pay and then cut them some slack when they don’t. 

For instance, if you sell an asset at a loss, the IRS allows you to deduct it from your taxable income, thereby reducing the impact on your finances. However, there are laws in place to prevent abuse. 

In this post, we explore the meaning of the IRS wash sale rule and the cases it applies to. If you sell an asset at a loss and want to make a legal taxable income deduction, make sure that you don’t buy a substantially similar asset in the near future. If you do, you could be regarded as breaking wash sale rules.

The Wash Sale Rule Explained

Wash sales occur when you sell a financial security in a taxable account and then buy back a similar or identical asset within 30 days of the original sale. The term “wash” comes from the phrase “it’s a wash,” meaning that the sale and repurchase have no meaningful impact on the asset allocation in your portfolio. IRS wash rules are designed to prevent this from happening. 

For clarity, a wash sale occurs when the following happens within 30 days of the sale of an asset or financial security:

• You buy an identical or similar stock or security for your share dealing account
• You purchase an identical stock or security for your IRA or Roth IRA
• You acquire a contract option to purchase an identical stock or security

Because losses are tax-deductible, some people attempt to use wash sales to reduce their income or capital gains tax burden. By selling assets at a loss when the market dips and then buying back soon after, they can claim a tax deduction without making any real changes to their portfolio mix.

Wash sale rules apply to all types of conventional financial assets, including exchange-traded funds, mutual funds, stocks, and bonds held in taxable accounts. They also prevent investors from transferring assets between different accounts. For instance, you cannot sell assets in your account and then buy them back in your spouse's account (within 30 days) and still qualify for a tax deduction. 

What Qualifies as a Wash Sale? 

What qualifies as a wash sale is pretty straightforward in the case of individual stock. For instance, if an investor sells Apple shares and then buys back their original position the next day, then the IRS will consider it substantially identical and, therefore, a wash sale. 

Nonetheless, things get complicated for pooled investments. As ETFs can contain hundreds of individual investments, many of them contain Apple stock. Therefore, the same investor who sells Apple shares and then buys an Apple-containing ETF may be falling foul of wash sale rules.

Similarly, investors may break wash sale rules when they switch from their current loss-making mutual fund to another within 30 days, claiming tax deductions in the process. Shifting from a tech-dominated mutual fund to a farming fund won’t trigger IRS wash sale rules but moving between two tech funds might.

It all depends on what the IRS can plausibly argue. In most situations, investors follow precedent (that is, what the IRS allowed in the past), or get professional financial advice. 

Interestingly, you’re at a higher risk of breaking wash sale rules when switching between passively managed funds, such as ETFs, than actively-managed mutual funds. Because ETFs just track markets, they often have broadly similar compositions.

The IRS might consider Vanguard's S&P 500 tracker ETF and MSCI’s S&P 500 tracker ETF as being substantially similar because they contain identical stocks in similar ratios. 

Unfortunately, the IRS doesn’t provide clear definitions of what it means by “substantively similar” or “substantially identical” securities. Hence, to be on the safe side, you may want to choose securities from different providers or industries. If in doubt, always talk to a financial advisor. 

Wash Sale Rule Examples

Discussing wash sale rules in theoretical terms can be a little vague. Therefore, in this section, we’ll take a look at some examples of a wash sale. 

Stocks

Suppose an investor buys Apple stocks on May 1, costing $20,000. He then sells them on June 1 for $15,000, incurring a loss of $5,000 which he uses for tax deduction purposes. If he makes no more trades in substantially similar securities within 30 days, he will not fall foul of wash sale rules. However, if he repurchases Apple stocks on June 15 (or any other date within the 30-day period following the sale), his tax deduction will be invalid. 

ETFs

Exchange-traded funds (ETFs) are bundles of financial securities that can contain equities, bonds, or even crypto. As such, they count as derivatives – a type of secondary market for investing. 

Let’s say an investor buys $5,000 worth of ARKK ETF on March 10, and then sells it on March 14 for $4,000, incurring a $1,000 loss. The investor can deduct the $1,000 loss from her taxable income for the year, as long as she doesn’t repurchase ARKK ETF within 30 days. If she does, she will be disqualified from the tax deduction.

Mutual Funds

Mutual funds are actively managed bundles of securities. Firms charge research fees for which they claim to provide customers with market-beating returns. Unfortunately, despite expert management, many mutual funds underperform and actually lose investors’ money. 

For instance, an individual could invest $100,000 in a mutual fund on November 1, and then sell on November 20 at a loss of $25,000. So as to avoid falling foul of wash sale rules, the investor must either wait 31 days before reinvesting capital with the mutual fund provider or choose a substantively different one. 

Do Wash Sale Rules Apply to Crypto?

Because cryptocurrencies are not conventional assets, the IRS says that wash sale rules do not apply. Therefore, crypto investors have the ability to sell tokens at a loss, take tax deductions, and then immediately repurchase coins without breaching any rules. 

Because of this, tax-loss harvesting is significantly more effective with crypto investments than with stocks and securities. Suppose you purchased $3,000 worth of Dogecoin on January 7, and then sold it for $2,500 on January 10, making a $500 loss. Under current rules, you could use the loss to reduce your taxable income, even if you immediately bought back Dogecoin after selling it. 

Congress has recently moved to close this loophole. However, as of the time of writing, there are still no wash sale rules for cryptocurrency, meaning that 2022 could be a great opportunity to reduce next year’s tax bill. 

Even so, cryptocurrency tax-loss harvesting transactions may fall foul of the Economic Substance Doctrine. For instance, the IRS may disallow certain transactions if the individual remains in the same economic position after the transaction takes place. 

Are There Any Wash-Sale Workarounds?

Once investors gain an understanding of the wash-sale rule, they often want to know whether there are any workarounds. Perhaps the most obvious tactic is to wait 31 days before repurchasing substantially similar assets. This way, investors can take a healthy tax deduction and then reestablish their former positions quickly afterward. 

Whether 31 days is an acceptable waiting period depends on the market. In highly-volatile situations, such as commodities or growth stocks, a delay like this may lead to fluctuations in the price. However, for value or blue-chip stocks, prices may not change much at all. 

Another strategy is to find a substantially different investment that fills the same niche in your portfolio. For instance, if you sold Apple stock, you could buy back the stock of a company with similar risk and performance characteristics, such as Google or Microsoft. In this case, the government would view the repurchase as materially different. 

You could also try buying back an ETF that contains the stock you sold. For instance, if you dumped Intel stock, you might consider buying back an S&P 500 ETF index tracker fund that contains the company’s shares, along with others. 

Similarly, if you already own a market-tracking S&P 500 ETF and want to replace it with something equally diversified, you might consider an index tracker that follows a different market, such as a NASDAQ or FTSE ETF. 

Lastly, you can get around the wash sale rule by sticking to a long-term investment plan. Instead of selling at the moment the market starts to dip and then buying back once it rises, just stay in the market. This way, you can avoid the inevitable panics that periodically consume investors and make returns over the long term. 

What Are the Tax Implications of a Wash Sale?

If you engaged in a wash sale, the IRS will not let you claim any losses against your current and future tax bills. Therefore, if you were counting on capital losses to offset your taxable income or capital gains, you could wind up owing more taxes than you expected. 

Are Wash Sales Illegal?

Wash sales themselves are not illegal. However, claiming a tax deduction on a wash sale is. 

As you might expect, the IRS does not care about how many times you buy and sell substantially similar securities during any 30-day period throughout the year. But it will start raising eyebrows if it notices that you are claiming tax deductions on wash sales. In many cases, it will deny the dedication at source, taking the full tax payment from you. 

In Conclusion

In this post, we answered the question “What is the wash sale rule?” Put simply, the wash sale rule means that you cannot claim tax deductions for losses that do not result in meaningful changes to your financial position. For instance, you can’t sell a share, claim a tax-deductible loss, and then immediately buy back the share, leaving your portfolio asset allocation unchanged. 

The purpose of wash sale rules is to prevent tax harvesting - a method that involves investing in highly volatile markets, selling at a loss, and using that for tax reduction purposes. The wash sale period is 30 days to expose individuals to sufficient risk to offset the immediate tax win.

Ultimately, the US tax code attempts to be fair to all participants. As such, the IRS allows individuals to offset genuine capital losses against taxable income. However, implementing such a rule is somewhat complicated in reality due to plenty of workarounds that taxpayers resort to.