A wash sale is a transactional sale of a security at a loss and repurchasing of the same or similar stock/security shortly before or after the financial year. If the security (stocks, bonds, options) is faring badly, the investor will sell it at a loss and repurchase the same after the start of the new financial year, whether it continues to be the same low price or at an even reduced price. Investors who resort to such a method of selling have continued to show a tax loss to gain an incentive.
For example: If a trader owns 500 shares of a certain security stock for which he paid $5000. He sells the shares today for an amount of $4000, which amounts to a loss of $1000. A few days later, he decides to repurchase the 500 shares and, it’s quite likely that the total value wouldn’t be a drastic difference from today’s price. In conclusion, he would still own the 500 shares with a loss of $1000. In this manner, a shrewd trader could design and create such wash sales to grow taxable losses that can offset his gains and avoid capital gains taxes.
This method of selling and repurchasing could be either intentional or unintentional, which is difficult to prove.
It’s difficult to determine the motive for a wash sale because a shrewd and active trader could be in and out of transactions quite frequently and trigger wash sales while losses are harvested discreetly.
The Wash Sale Rule
This rule designates that if an investor buys stock/security within 30 days after selling it, and any outcome from that sale cannot be counted against reported income. This effectively would remove the motive to attempt a short-term wash sale.
The wash sale rule applies to all trade stocks, bonds, mutual funds, and other security options, i.e., any investment which generates a taxable financial gain.
The Internal Revenue Service (IRS) implemented the wash sale rule to prevent the misuse of the incentive benefit scheme in the US.
Interpretation of The IRS Wash Sales Rule (IRC Section 1091)
This means that if you decide to close a trade at a loss and then repurchase the same as equivalent equity, the IRS stipulates that the loss cannot be carried forward. The loss must be moved forward and get attached to the cost basis of trade in which the same stock was bought in.
If the cycle of trading continues to occur very often within the 30-day window at a loss and you purchase equivalent equity again, then the loss must move forward.
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Negative Consequences of Wash Sales
If the repurchased shares that triggered a wash sale were either
1) held open at year-end or
2) purchased in January of the new financial year,
the IRS stipulates that the loss is disallowed for the current financial year, and therefore the loss gets carried forward to the subsequent year or whichever year the shares are finally disposed of.
In addition, a wash sale could have an effect on the holding period of trade. For example, if a long term holding was closed for a loss and then repurchased within the 30-day window, then the loss is carried forward to the value basis of new trade. The holding period for the new trade will begin from the same day for a long term basis.
So even if the new trade was closed prematurely within the year, the IRS makes it mandatory for a report on the new trade as an extended-term gain or loss.
Ethical Aspect of a ‘Wash Sale’
History has been witness to a series of manipulative market acts. For many decades, it was considered to be one of the main ways to make money in an unregulated stock and commodity market. One of the most common forms of manipulation is/was ‘Wash Sales.’
It was originally a straightforward act of manipulation to realize tax losses by selling and repurchasing at a later point in time. The question remains whether it is ethical to do so or merely a rule of the game.
The speculative form of buying and selling of stocks serves no meaningful purpose because it merely diverts wealth from a productive economy into the financial sector. It results in an overall net loss. From this perspective, it could be viewed as an ethical case to lower the stringency of law and look forward to a solution that would limit the volume of derivative securities that can be traded. In this manner, it would reduce the overall non-compliance percentage.
Application of Wash Sale Rules on ETFs, Mutual Funds and Options
Wash Sale rules apply to stock/security instruments that carry a CUSIP (Committee on Uniform Securities Identification Procedures) number. Additionally, selling a stock at a loss and then buying a stock/security option of the same quantity will trigger the wash-sale rule.
ETFs (Exchange Traded Funds) and mutual funds pose a challenge to investors. Switching from one ETF to a similar ETF offered by a different company could trigger a wash-sale. There are ways to work around a solution to this problem. For example, an investor holding an ETF indexed to S&P 500 at a loss might consider switching over to an ETF or open-ended fund that’s indexed to a special set of securities, like the Russell 1000 or Dow Jones Industrial Average.
In the United States, it is mandatory to report loss adjustments arising out of wash sales on Form 1099-B.
It’s a general observation that most brokers do not report wash sale (WS) loss calculations during the year.
All US taxpayers must compute their WS losses across all brokerage accounts, including IRAs and spousal accounts, if filing jointly.
Investment scenario in an economy is ever-changing due to business dynamics that impact economies of scale. All investors must remain cautious and trade carefully either due to volatility on the bourses or due to amended compliance norms.
With the passage of time, financial regulatory authorities are beginning to tighten their grip and monitor questionable financial transactions. Hence, it is in the best interest of investors to stay compliant with the norms of trading.