Wash sales can impact a position's cost basis and are an important part of income taxation of investments. The IRS created the wash sale rule to prevent investors from artificially inflating their cost basis.
What is a stock wash sale?
A stock wash sale occurs when a stock or security is sold or traded at a loss, and within 30 days of the sale, the account holder:
- Buys substantially identical stock or securities
- Acquires substantially identical stock or securities in a fully taxable trade
- Acquires a contract or option to buy substantially identical stock or securities
- Acquires substantially identical stock or securities in an IRA or Roth IRA
If an account owner sells stock and their spouse buys a substantially identical stock, a wash sale also occurs. If a loss is disallowed because of wash sale rules, the loss is added to the new stock or securities’ cost basis.
For example, on June 1, Bob sells XYZ stock at $200 for a $50 loss. On June 15, Bob repurchases XYZ stock at $205.
Because the repurchase was within 30 days of the June 1 loss, the June 15 purchase cost is adjusted higher (from $205 to $255) because of the wash sale loss. The wash sale adjustment essentially postpones or delays the loss deduction until the newly acquired shares are sold.
The goal of the wash sale rule is to prohibit investors from selling securities at a loss and claiming the loss as a deduction while continuing to hold a position in the same or similar security. Without the wash sale rule, an investor may sell a security at a loss just to receive a tax deduction and lower income tax liability and then re-enter the position.
The holding period for the new purchase in a wash sale includes the period the old stock was held. The wash sale rule was designed to discourage selling securities at a loss simply to claim a tax benefit.
"Substantially identical security" defined
The definition of “substantially identical stock or securities” is found on page 56 of IRS Publication 550.
The IRS describes a “substantially identical” security as follows:
In determining whether stock or securities are substantially identical, you must consider all the facts and circumstances in your particular case. Ordinarily, stock or securities of one corporation are not considered substantially identical to stock or securities of another corporation. However, they may be substantially identical in some cases. For example, in a reorganization, the stocks and securities of the predecessor and successor corporations may be substantially identical.
This generally includes securities of the same company, options on the same security, and even certain ETFs that track the same index.
Selling a stock for a loss and then buying a call option on the same security is likely to trigger a wash sale because acquiring “a contract or option to buy substantially identical stock or securities” is explicitly described by the IRS as a reason for a wash sale.
For investors, it’s essential to be aware of the wash sale rule and how it can impact trading decisions. While the rule is meant to discourage investors from claiming a tax benefit, it can also delay the deduction of losses on investments.
When in doubt, it’s always best to consult with a tax professional to ensure that you comply with the rules.