Contrary to what it sounds like, a wash sale has nothing to do with the laundry market or a dishwasher store. In financial terminology, a wash sale and a wash sale rule are important concepts for investors. This article tells you everything you need to know about a wash sale.
What is a wash sale?
Before we begin, let us first understand what is a wash sale. A wash sale is a transaction where an investor aims to get tax benefits by selling a security (stock or bond or stock option) at a loss at the end of a calendar year so that they can claim a capital loss on taxes for that year. This concept exists if a country’s tax laws allow tax deductions on securities held within a certain tax year.
How it works:
A wash sale has three parts to it:
- If an investor knows he is going to make a loss on a stock, he sells the stock just before the tax year ends.
- They are allowed to take a loss that they can legally claim on their tax returns as a reduction of earnings i.e., they pay a lesser tax.
- Once the next year begins – within 30 calendar days – the investor will purchase the same stock (or a “substantially identical,” security), possibly at a lower price, to regain the same portfolio.
At first glance, this seems like an obvious loophole in the system that helps an investor avoid taxes that he should be paying. Preventing investors from exploiting this is the motivation for introducing the wash sale rule.
Another seemingly confusing term is “substantially identical”, which is elaborated later in the article.
The wash-sale rule
The wash-sale rule is a rule established by the Internal Revenue Service (IRS) that prevents an investor from getting tax benefits for a security sold in a wash sale. It goes by different names in different countries (for example, “bed-and-breakfasting” in the UK). It is important to remember that a wash sale, as such is not illegal, but what is illegal is claiming a fraudulent tax benefit.
Consider an example where your income is $20,000 (and 20% is capital gains tax), and you own, say, 200 Google (GOOG) shares at $40 per share. Towards the end of the year, they are valued at $30, so you sell all of them and report a loss of $2,000. This will change your taxable income from $20,000 to $18,000, and you end up paying lesser tax (20% of $18,000 is $3,600 as opposed to the $4,000 you should have paid).
Note that if an investor does the opposite i.e., sells a security at a gain at the end of the year and buys it back within 30 days, the gain is anyway taxable.
How do you avoid violating wash-sale rules?
There are some (perfectly legal) ways of keeping yourself in the hunt even during the wash-sale period until it expires.
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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. Exposure is an indication of how much an investor can potentially lose due to risks in a particular environment.
So, if you sell your stocks at a loss but buy a security with similar exposure, your portfolio is more or less the same, but the trade will not come under a wash sale. This is commonly done with a type of security called exchange-traded funds (ETFs).
2. What is “substantially identical”:
Shares of ExxonMobil and Reliance are not substantially identical because even though both companies are in the energy sector, their operations are vastly different. Similarly, shares of Facebook and Google can’t be considered identical either. So, you can maintain your portfolio in nearly the same way but by cleverly taking advantage of what substantially identical implies.
3. Index funds:
You can replace one index fund with another index fund of the same index (like the S&P 500). If they have different expense ratios, they are not considered substantially identical. There is no explicit rule against this, but risk-averse investors usually don’t try this out.
4. Tax-loss selling:
Tax-loss selling is selling some of your assets at a loss to offset the capital gains you get from another asset. Even though a lot of tax-loss selling happens only at the end of the year, it is advisable to capture tax losses throughout the year as you balance your portfolio.
For example, if you have some bad assets in your portfolio, but you also own real estate (land, say)which fetches you a hefty price, you can sell the land and also the bad assets, and use the loss to reduce the tax liability on the capital gains from the land.
5. Multiple accounts:
The wash-sale rule applies to the investor, not a particular account. An investor is required to track and report sales in all their accounts to check for wash sales. Note that a company owned by the investor can also buy back the security, and it also counts as a wash sale.
6. Call and put options:
Disclaimer: this method is a trap, and it definitely will not work. While you might feel that buying a stock and having the right to buy a stock (call option) are not the same thing, the wash-sale rule clearly states that you can’t have a “contract or option to acquire” a security that you sold.
A put option (the right to sell a stock) will surely get you into trouble if it is likely to be exercised because the loss on the original shares will be added to the cost basis of the new shares, thereby erasing any potential benefit that seemed possible.
Want to try your hand at stock trading?
This article covered a lot of technical jargon and complex rules, which might be difficult to understand in theory. There are plenty of virtual stock trading platforms online where you can get free stocks to own and trade with virtual money, giving you a taste of and gearing you up for the real stock exchange.