This article elaborates on the wash-sale rule, an important regulation in the stock market established by the Internal Revenue Service (IRS). You will know what it is and how to avoid or work around the rule as an investor. Read on!
Wash Sale: Definition
So what is a wash sale? It is a transaction where an investor aims to get tax benefits by selling the security (could be stocks, bonds, or options) at a loss at the end of a calendar year so that they can claim a capital loss on taxes for that year.
How a Wash Sale Works
- If an investor knows he is going to make a loss on a stock, he/she sells the stock just before the tax year ends.
- If the country's laws permit it, they can take a loss that they can legally claim on their tax returns as a reduction of earnings i.e., they pay lesser tax.
- When the next year begins - within the next 30 calendar days - the investor purchases the same security (or a "substantially identical" one), possibly at a lower price, to regain the same portfolio.
Even if you didn't understand all the intricacies of the three statements, it seems like an obvious loophole in the system that enables investors to avoid taxes that they should be paying.
The Wash-Sale Rule
This rule was brought in to prevent investors from claiming fraudulent tax benefits. That is illegal, even though a wash sale, as such, is within the limits of stock trading. The rule states that if an investor does purchase the same or substantially identical security within 30 days, the proceeds from that transaction would still be taxable.
Here is an example to illustrate the concept better (following the same three steps mentioned above).
- Your income is $10,000, and you own 100 shares of XYZ trading at $50. At the end of the year, they are trading at $40, so you sell all of them.
- You now have a loss of 100 X 10 = $1000, and if you claim this loss, your taxable income reduces to $9000. So, if capital gains tax is set at 20%, you should have paid $2000 as tax, but you only pay $1800 now.
- Within 30 days, you purchase substantially identical securities (of another company, ABC, say), to retain a similar portfolio.
How To Avoid The Wash-Sale Rule
Here are four strategies you can follow to avoid violating the wash-sale rule.
1. Buy Another Security With Similar Exposure
Market exposure refers to the fraction or percentage of an investor's portfolio invested in a particular type of security, market sector, or industry. In other words, this is a measure of how much risk an investor has in a particular environment.
By buying other stocks or bonds with similar market exposure, your portfolio will remain the same, but this purchase won't come under a wash sale. This sort of transaction is commonly done with the help of exchange-traded funds or ETFs.
2. Identical But Not Substantially Identical Securities
Convertible securities and common stock of the same corporation are considered to be "substantially identical." So, Apple equities and Apple options would be labelled substantially identical.
By this definition, shares of ExxonMobil and Reliance are not substantially identical, even though they are both in the energy sector. Their operations are vastly different, as well.
So, if you sell Exxon stocks at a loss at the end of one calendar year, you can purchase Reliance stocks within 30 days and claim a capital loss on taxes. Your portfolio is nearly identical, and you have not broken the wash-sale rule.
3. Invest In Index Funds
An index fund is a sort of mutual fund designed to track the components of a financial market index, such as the S&P 500. If you invest in index funds and you sell one of them at a loss at the end of a calendar year, you can buy another index fund of the same index, and this won't be considered a wash sale. However, this is a strategy that is usually carried out only by high-risk traders.
4. Tax-loss Selling
Tax-loss selling is the process of selling some of your assets at a loss to offset the capital gains you get from another asset. This does not deal with wash sales exactly, but it is another legal way to reduce your tax liabilities.
If you have some bad assets in your portfolio and you also own some property that sells at a very profitable price, you can also sell the bad assets at the end of the year at a loss. You can use this loss to offset the heavy gain from the land, and hence, pay lesser taxes.
What Happens If You Are Caught?
If the IRS determines that your transaction was a wash sale, then you cannot use the loss on the sale to reduce taxable income. Moreover, your loss is added to the cost basis of the new investment, and the holding period of the investment you sold is also added to the holding period of the new investment.
Of course, there might be times when you make a lesser loss in this case compared to the case where you sell the assets without purchasing anything else. But, being booked by the IRS for fraud of any sort creates a bad record, so you are better off not violating the rule.
Are You Ready to Trade?
The wash-sale rule is one of the more complicated nuances in stock trading, so it might be difficult to grasp the concept in theory. However, several online stock brokerages let you trade with free stocks and virtual money just to give you the experience of the real market. You can test out the wash-sale rule and other strategies on such platforms before entering the actual market.
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