Tax-loss selling is an investment strategy that can help an investor reduce their taxable income for a given tax year. Tax-loss selling involves selling a security that has experienced a capital loss in order to report it as a capital loss when filing yearly income taxes, and thus lower or eliminate any capital gain that may be realized by other investments.
In order to successfully realize the loss for tax purposes, you have to take the step of liquidating the position during the tax year. Any unrealized loss on an investment cannot be deducted from your income taxes.
Sometimes an investor will decide to replace that security with a similar security, allowing them to maintain a consistent, optimal asset allocation and achieve their desired returns. If you take this approach, it is important to be mindful that you do not accidentally trigger a wash sale in your investment account.
Key Takeaways
- Wash-sale rules prohibit investors from selling a security at a loss, buying the same security again, and then realizing those tax losses through a reduction in capital gains taxes.
- Tax-loss selling is an investment strategy that can help an investor reduce their taxable income for a given tax year; investors may be able to claim up to $3,000 in capital losses per year in order to offset their taxable income (if they are married filing jointly).
- A common strategy for avoiding violating the wash-sale rule is to sell an investment and buy something with similar exposure.
What Is a Wash Sale?
A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days of the sale (either before or after), you purchase the same—or a "substantially identical"—investment. The wash-sale rule is a regulation established by the Internal Revenue Service (IRS) in order to prevent taxpayers from being able to claim artificial losses in order to maximize their tax benefits.
When a wash sale occurs in a non-qualified account, the transaction is flagged and the loss is added to the cost basis of the new, "substantially identical" investment you purchased. If you continue to trade the same investment, the loss gets carried forward with each transaction until the position has been fully liquidated for more than 30 days.
The same rules apply if the spouse of the individual that sells the security, or a company controlled by that individual, purchases the same or substantially equivalent securities within the 30-day timeframe.
In addition, your holding period for the new stock or securities (for designating whether or not the investment will represent a short- or long-term capital gain) includes the holding period of the stock or securities that were previously sold.
Investments Subject to Wash Sale Rules
The wash-sale ruleapplies to stocks or securities in non-qualified brokerage accounts and individual retirement accounts (IRAs). The sale of options at a loss and the reacquisition of identical options within a 30-day timeframe would also violate the wash-sale rule.
The IRS provides guidelines about what is considered a "substantially identical" investment and thus may trigger a wash-sale violation, in IRS Publication 550, entitled "Investment Income and Expenses (Including Capital Gains and Losses). A substantially identical investment can include both new and old securities issued by a corporation that has undergone reorganization, or convertible securities and common stock of the same company.
When an investor holds several different investment accounts, wash-sale rules apply to the investor, rather than to a specific account. The IRS requires that brokers track and report any sales of the same CUSIP number in the same non-qualified account. However, investors are responsible for tracking and reporting any sales that occur in all other accounts that they control, including any accounts belonging to their spouse.
Offset Capital Gains Through Tax-Loss Selling
While some investors turn their attention to tax-loss selling towards the end of the calendar year, it is possible to use this strategy throughout the year to capture tax losses through rebalancing or replacing positions in your portfolio. Capital losses are used first to offset other taxable capital gains. After this, up to $3,000 per year can be used to offset other taxable income for an individual filer or married couple filing jointly (up to $1,500 for married filing individually).
For example, if an investor realizes $5,500 in long-term losses during the year, at the time that they file their income taxes, they can use $2,000 of those losses to offset the taxes on other capital gains and $3,000 to offset the taxes on their ordinary income. If this investor's long-term capital gains tax rate is 20% (based on their income) and their effective federal income tax rate is 25%, using this strategy the $5,500 loss can be reduced by $1,150.
Depending on the state they live in, the investor may also be eligible for a reduction in their state taxes. The remaining $500 in capital losses can be carried forward to future tax years. Unfortunately, losses cannot be transferred at death.
Strategies for Avoiding Wash Sales
There are strategies for avoiding wash sales while still taking advantage of taxable gains and losses. If you own an individual stock that experienced a loss, you can avoid a wash sale by making an additional purchase of the stock and then waiting 31 days to sell those shares that have a loss. A potential drawback of this strategy is that it can increase your market exposure to a given sector and could potentially increase your risk.
In this same situation, an investor may decide to liquidate the holding, recognize the loss, and then immediately buy a similar investment that will also satisfy their investment goals or portfolio allocation.For example, an investor may decide to sell their stock of The Coca-Cola Company (KO) and then immediately purchase a similar investment of PepsiCo, Inc. (PEP).
Similarly, an investor may decide to sell their shares of the Vanguard 500 Index Fund (VFIAX) and replace them by purchasing shares of the Vanguard Total Stock Market ETF (VTI).
Correction: Jan. 20, 2022. The offset amount for individual taxpayers was incorrectly specified in a previous version of this article.
FAQs
How do you avoid wash sale loss disallowed? ›
If you own an individual stock that experienced a loss, you can avoid a wash sale by making an additional purchase of the stock and then waiting 31 days to sell those shares that have a loss.
How do you circumvent a wash sale rule? ›How to avoid a wash sale. One way to avoid a wash sale on an individual stock, while still maintaining your exposure to the industry of the stock you sold at a loss, would be to consider substituting a mutual fund or an exchange-traded fund (ETF) that targets the same industry.
When the wash sale rules apply the realized loss? ›The answer is D) not recognized at time of sale and added to basis of the newly acquired stock.
What happens if I accidentally do a wash sale? ›If you accidentally (or intentionally) write off the loss on a wash sale, the IRS will re-figure your tax and bill you for the difference.
How do day traders avoid wash sales? ›Wait 30 Days
Waiting to buy the same, or a similar, investment for the full 30-day period after you sell your investment is the surest way to avoid a wash sale. (You'll also want to make sure you didn't buy the same, or a similar, investment the day you sold or in the 30 days leading up to your sale.)
Since the IRS can see the tax documents sent by your brokerage (see the pattern here?), trying to claim a loss in a wash sale is good way to invite an audit. In addition to these investor-specific tax mistakes, there are many other ways you can bring on a tax audit.
Do day traders care about wash sales? ›Overview. Generally, the wash sale rule applies to traders the same way it applies to investors. The difference is that traders have a much harder time keeping records relating to wash sales because they engage in so many transactions.
Are wash sale losses gone forever? ›Your loss is a "wash" in this scenario, just as though you had held your original shares without selling. The tax benefit of your capital loss isn't gone forever, but it's deferred.
What triggers the wash sale rule? ›The wash sale rule prohibits taxpayers from claiming a loss on the sale or other disposition of a stock or securities if, within the 61-day period that begins 30 days before the sale (generally, the trade date) or other disposition, they: Acquire the same or a “substantially identical” stock or securities; or.
Can I sell a stock for a loss and buy it back? ›A wash sale occurs when you sell or trade a security at a loss, and then rebuy or acquire the same security within a short period of time. Of course, losses can be valuable for some investors. This is partly because losses can be used to offset same year gains and potentially reduce capital gains taxes.
Does IRS detect wash sales? ›
Brokers track and report wash sales within the same account and include the sales in the gain and loss report to the IRS. However, if the trades are in different accounts, you are responsible for tracking wash sales.
Do I pay taxes on wash sale loss disallowed? ›If you have a loss from a wash sale, you can't deduct the loss on your return. However, a gain on a wash sale is taxable.
Is there a tax penalty for a wash sale? ›Wash Sale Penalty
Claiming the tax loss on a wash sale is, however, illegal. The IRS does not care how many wash sales an investor makes during the year. On the other hand, it will disallow the losses on any sales made within 30 days before or after the purchase.
- Open a cash account. If a day trader wants to avoid pattern day trader status, they can open cash accounts. ...
- Use multiple brokerage accounts to avoid the PDT Rule. ...
- Have an offshore account. ...
- Trade Forex and Futures to avoid the PDT Rule. ...
- Options trading.
The wash-sale rule states that, if an investment is sold at a loss and then repurchased within 30 days, the initial loss cannot be claimed for tax purposes. So, just wait for 30 days after the sale date before repurchasing the same or similar investment.
How do day traders not get good faith violations? ›The best way to avoid a good faith violation is by trading only with settled cash and steering clear of trading with unsettled funds. Before trading, it's good to make sure that the cash in your account will cover your purchase.
Who gets audited by IRS the most? ›The big picture: Black Americans at all levels of the income spectrum get audited at significantly higher rates, according to an extremely important new study conducted by Stanford researchers with the cooperation of the IRS.
How does the IRS find out about unreported income? ›The IRS receives information from third parties, such as employers and financial institutions. Using an automated system, the Automated Underreporter (AUR) function compares the information reported by third parties to the information reported on your return to identify potential discrepancies.
How does IRS verify cost basis? ›Preferred Records for Tax Basis
According to the IRS, taxpayers need to keep records that show the tax basis of an investment. For stocks, bonds and mutual funds, records that show the purchase price, sales price and amount of commissions help prove the tax basis.
Under the wash-sale rule, you cannot deduct a loss if you have both a gain and a loss in the same security within a 61-day period. (That's calendar days, not trading days, so weekends and holidays count.)
Can day trader deduct wash sale losses? ›
You cannot deduct losses from sales or trades of stock or securities in a wash sale unless the loss was incurred in the ordinary course of your business as a dealer in stock or securities.
How do day traders avoid capital gains tax? ›The first way day traders avoid taxes is by using the mark-to-market method. This method takes advantage of the ability of day traders to offset capital gains with capital losses. Investors can get a tax deduction for any investments they lost money on and use that to avoid or reduce capital gains tax.
Is tax loss harvesting worth it? ›Tax-loss harvesting is undoubtedly worth the effort in most cases (but not all). If done correctly, tax-loss harvesting can lead to higher overall portfolio returns. Yet, most investors do not implement this strategy.
Should I sell stocks at a loss for tax purposes? ›Tax-loss harvesting is a way to cut your tax bill by selling investments at a loss in order to deduct those losses on your taxes. Deducting those losses can offset some or all of the capital gains tax you might owe on other investments that you sold for a profit.
Should you ever sell at a loss? ›When Should You Sell a Stock At a Loss? This depends on your trading strategy and overall portfolio composition. You may be able to hold stock at a loss for a longer period if it is a smaller part of your portfolio and doesn't drag your portfolio's value down.
At what percent loss should I sell stock? ›To make money in stocks, you must protect the money you have. Live to invest another day by following this simple rule: Always sell a stock it if falls 7%-8% below what you paid for it. No questions asked.
Does TurboTax check for wash sales? ›Open or continue your return in TurboTax and search for wash sales. Select the Jump to link at the top of the search results. Answer Yes to Did you sell any investments in 2022?
How do I put wash sale loss disallowed on Turbotax? ›On the screen, Tell us about your 1099-B, mark the button I'll enter one sale at a time. Enter the information on the sale and then click the box I'll enter additional info on my own. Enter the disallowed wash sale loss in box 1g and select Done to record the information.
What is an example of wash sale loss disallowed? ›Practical Example: Wash Sale
He then repurchased the shares on August 10 when the shares were trading at $33 per share. Since the transaction occurred within the 30-day wash sale period, the $300 loss is a wash sale and would be disallowed by the IRS.
The tax benefit of your capital loss isn't gone forever, but it's deferred. The loss on the original investment will be taken into account when you sell your replacement shares by applying the losses to your adjusted cost basis.
Do you have to claim wash sale loss disallowed? ›
The wash-sale rule states that, if an investment is sold at a loss and then repurchased within 30 days, the initial loss cannot be claimed for tax purposes. So, just wait for 30 days after the sale date before repurchasing the same or similar investment.
Can a wash sale be reversed? ›Some investors may think that they can reverse the order of a wash sale, buying more of the asset before they later sell less than 30 days later and declare a loss on it. But the IRS disallows this activity, since you may not buy 30 days before or after the sale and still claim a loss.
How long does it take to stop a wash sale? ›So, you're working with the wash sale 61-day rule—a 61-day period where you need to avoid rebuying the same stock. For some investors, waiting 61 days to rebuy stock or security isn't ideal for whatever reasons.
Can a day trader deduct wash sale losses? ›You cannot deduct losses from sales or trades of stock or securities in a wash sale unless the loss was incurred in the ordinary course of your business as a dealer in stock or securities.
Do brokerages keep track of wash sales? ›Brokers track and report wash sales within the same account and include the sales in the gain and loss report to the IRS. However, if the trades are in different accounts, you are responsible for tracking wash sales.
What happens to wash sale loss disallowed? ›You'll need to figure the basis for shares sold in a wash sale. When you do, add the amount of disallowed loss to the basis of the shares that caused the wash sale. These are the new shares you received. By doing this, you defer the loss, but it's not disallowed for good.