Financial Advisor: Wash-Sale Rule

Seller's remorse can strike in a bearish market, or you might wish to offset losses without giving up a promising investment. Whatever the case may be, when you decide to sell an investment at a loss, it becomes crucial to steer clear of acquiring a "substantially identical" investment within 30 days before or after the sale. This regulation is known as the wash-sale rule and disregarding it can result in unforeseen tax liability.

What is a Wash-Sale?

A wash sale happens when you sell something and quickly buy it back, often at the same price. It is also called wash trading. This action is analogous to the saying "it's a wash" because it doesn't significantly impact your portfolio composition or performance.

The primary motivation behind engaging in wash trading is to claim a loss for tax purposes. The IRS allows individuals and couples to subtract up to $3,000 in losses from their income when filing taxes. In the case of married couples filing separately, each spouse can deduct up to $1,500 from ordinary income.

If your realized losses exceed $3,000, you can carry over the excess losses into future tax years in increments of $3,000. This allows you to potentially offset gains in future years and reduce your overall tax burden.

What is the wash-sale rule?

Selling a money-losing investment in a taxable account can yield a tax benefit. However, to prevent investors from exploiting this, the wash-sale rule comes into play. This rule prohibits you from selling an investment at a loss and then repurchasing the same (or "substantially identical") investment within a 61-day window to claim the tax benefit. The rule applies to various investments held in brokerage accounts or IRAs, such as stocks, bonds, mutual funds, ETFs, and options.

To be more specific, the wash-sale rule states that if you buy the same security, a contract or option for it, or a "substantially identical" security within 30 days before or after selling the loss-generating investment, the tax loss will be disallowed (within the 61-day window).

You cannot sell an investment at a loss in a taxable account. You also cannot buy it back in a tax-advantaged account.

This is to avoid the wash-sale rule. Furthermore, the IRS maintains that if one spouse sells a stock at a loss and the other spouse buys it within the restricted time frame, it is still considered a wash sale. For personalized advice on your specific situation, it's best to consult a tax advisor.

How to avoid a wash-sale.

To sidestep a wash sale while still maintaining exposure to the industry of the stock you sold at a loss, you can explore the option of replacing it with a mutual fund or an exchange-traded fund (ETF) that targets the same industry.

ETFs can prove especially useful in avoiding the wash-sale rule when dealing with loss-generating stocks. Certain ETFs are created to concentrate on particular industries, sectors, or small groups of stocks.

These ETFs differ from broad-market index ETFs such as the S&P 500. These special ETFs make it easy to invest in a specific industry or sector without buying individual stocks. They hold a variety of different securities, so they are not exactly the same as any one stock.

When exchanging ETFs or switching from an ETF to a mutual fund, it is crucial to exercise caution. This is because the rule regarding similar securities can be perplexing. The IRS determines if your transactions violate the wash-sale rule. This is because there are no specific guidelines on what qualifies as very similar securities.

Such violations could result in unexpected tax obligations for the year. If you are unsure about your situation, it is recommended to seek assistance from a tax expert or financial professional. They can help you understand and comply with the rules, thereby preventing any potential tax problems.

What is the wash-sale penalty?

If the IRS determines that your transaction was a wash sale, several consequences follow. First, you won't be allowed to use the loss from the sale to offset gains or reduce your taxable income. Instead, the loss amount will be added to the cost basis of the new investment. Additionally, the holding period of the investment you sold will also be combined with the holding period of the new investment.

In the long term, this may have a potential upside due to a higher cost basis. Selling your new investment could result in a bigger loss. Alternatively, if the investment value increases and you decide to sell, you may owe less on the profit.

Holding onto the investment for a longer time may qualify you for a lower tax rate on profits. This is in contrast to a higher rate for shorter-term investments.

In the short term, you can't use the loss to offset gains or lower your taxable income. Getting a letter from the IRS saying the loss is not allowed is not good, so it's better to be careful. If you're worried about buying a new investment, wait for at least 30 days after selling the old one. Alternatively, seek assistance from a financial professional who can confidently navigate the intricacies of taxes and investments.

Bottom Line

The U.S. tax code lets you sell investments that lose money to reduce how much you have to pay in taxes. To avoid breaking the wash sale rule, be cautious about purchasing the same security or a similar one too quickly. Always consult with your financial advisor to make sure you are not breaking the was sale rule.

Sources:

What Is The Wash Sale Rule? – Forbes Advisor

https://www.fidelity.com/learning-center/personal-finance/wash-sales-rules-tax

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Inverse/Leveraged ETF. Leveraged and inverse exchange traded funds ("ETFs") are for sophisticated investors who understand their risks including the effect of daily compounding of leveraged investment results and for accounts that will be actively monitored and managed on a daily basis. These products require an Aggressive Growth Investment Objective and a High Risk stated risk tolerance on an executed Confidential Investor Profile to purchase. The more an ETF invests in leveraged instruments, the more the leverage will magnify any gains or losses on those investments. Inverse ETFs involve certain risks, which include increased volatility due to the ETF's possible use of short sales of securities and derivatives, such as options and futures. The ETF's use of derivatives, such as futures, options and swap agreements, may expose the ETF's shareholders to additional risks that they would not be subject to if they invested directly in the securities underlying those derivatives. Short-selling involves increased risks and costs. You risk paying more for a security than you received from its sale. Leveraged and inverse ETFs seek to provide investment results that match the performance of a specific benchmark, before fees and expenses, on a daily basis. Inverse ETFs should lose money when their benchmarks or indexes rise - a result that is opposite from traditional ETFs. ETFs are non-diversified investments. These risks can increase volatility and decrease performance.