What Is the Wash-Sale Rule?
The wash-sale rule is a tax regulation enforced by the IRS that prevents investors from writing off a loss on the sale of a security if they purchase the same or a substantially identical security within a 61-day window — 30 days before the sale, the day of sale, and 30 days after. It aims to stop taxpayers from creating artificial losses for tax deductions while maintaining their investment positions.
Background and Purpose
Before the wash-sale rule was enacted, investors could sell losing stocks near the end of the tax year, claim the loss to reduce taxable income, and then quickly buy back those securities. Since the investor never truly relinquished ownership risk, this was considered a loophole allowing abuse of the tax code. To promote fairness and tax compliance, the IRS implemented the wash-sale rule, which requires a real economic loss before allowing a tax deduction.
How the Wash-Sale Rule Works: A Practical Example
Suppose you purchased 100 shares of XYZ Corporation at $50 per share. The market price then drops to $30 per share. You sell all your shares on December 1 to realize a $2,000 loss ($20 loss per share × 100 shares). If you buy the same 100 shares again on December 20 (just 19 days later), the wash-sale rule applies because you repurchased within the 30-day window.
As a result, the $2,000 loss cannot be deducted on your current year tax return. Instead, the loss is added to the cost basis of the newly purchased shares, increasing it from $3,000 (100 shares × $30) to $5,000 ($3,000 + $2,000 deferred loss). This means your tax loss is deferred until you sell the new shares outside the wash-sale window.
Securities Covered
The wash-sale rule applies broadly, including to:
- Stocks
- Options on stocks
- Mutual funds and ETFs, if they are “substantially identical”
Notably, the IRS considers buying a nearly identical security, such as an ETF tracking the same index as a sold ETF, as triggering the rule.
Accounts and Wash Sales
This rule applies only to taxable accounts. Transactions within tax-advantaged retirement accounts (such as IRAs or 401(k)s) are generally exempt. However, if you sell a security at a loss in a taxable account and buy the same security in an IRA within 30 days, the loss deduction is permanently disallowed. This special case is explained in IRS Publication 550.
How to Avoid Wash-Sale Rule Traps
- Wait 31 days before repurchasing: The simplest method is to wait more than 30 days to buy back the security.
- Buy similar but not substantially identical securities: For example, invest in a different ETF that tracks a related but not identical index to avoid triggering the rule.
- Use tax-loss harvesting carefully: This strategy involves selling securities at a loss to offset gains. Proper timing and record-keeping are vital to avoid wash sales.
- Track transactions closely: Using investment software or consulting a tax professional helps ensure you don’t inadvertently trigger wash sales.
Common Misconceptions
- The rule doesn’t just cover the same stock but also “substantially identical” securities including certain options and ETFs.
- The 30-day period applies both 30 days before and 30 days after the sale, totaling a 61-day window around the transaction.
- You are not prohibited from buying the security indefinitely; just avoid repurchasing within the 61-day window.
FAQs
Q: What happens when a wash sale is triggered?
A: The loss is not immediately deductible but added to the cost basis of the replacement shares, deferring the tax benefit until those shares are sold outside the wash-sale window.
Q: Can wash sales occur across different brokerages?
A: Yes, the IRS combines holdings across all brokerage accounts you control.
Q: Does the rule apply to ETFs and mutual funds?
A: Yes, if they are substantially identical. For example, selling Shares of one S&P 500 ETF and buying another tracking the same index may trigger the rule.
Q: Does the wash sale rule affect inherited or gifted stocks?
A: Generally, no. These transactions follow different IRS rules and typically do not trigger wash sales.
Related Articles
- Form 8949 – Sales and Other Dispositions of Capital Assets explains the IRS form used for reporting capital gains and losses, including those affected by wash sales.
- Learn more about Tax-Loss Harvesting strategies to reduce taxable income legally.
- Understand how Cost Basis adjustments work after wash sales.
Summary Table: Wash-Sale Rule
| Aspect | Details |
|---|---|
| Applies to | Stocks, options, mutual funds, ETFs |
| Timeframe | 30 days before and after the sale |
| Effect on losses | Losses disallowed currently; deferred by adding to cost basis |
| Exemptions | Retirement accounts (special rules apply) |
| Purpose | Prevent artificial tax loss claims |
| Avoidance tips | Wait 31+ days, buy different securities |
For full details, consult IRS Publication 550, which provides official guidance about investment income and expenses including wash-sale rules.
Understanding this rule empowers investors to manage tax implications of investment losses effectively, optimizing tax outcomes without crossing IRS restrictions.