|The Wash Sale Rule|
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The wash sale rule...
Investors and regular Traders are both subject to the wash sale rule. M2M Traders and Dealers are generally exempt from the Wash Sales Rules for those securities used in their business. This IRS rule (§1091 & §267) limits and defers the current deduction of losses in actively traded securities if you buy and sell substantially the same security within a 61-day window (also referred to as being from "30 days before the sale until 30 days after the sale").
This includes common & preferred stocks and put & call options on those stocks as well as other securities and debt instruments but excludes futures contracts and foreign currencies. Even if a stock is sold and bought on the same day, the wash sale can apply to that transaction. Short sales likewise are subject to the rule. Creative "games" like a wife selling her stock followed by a purchase by her husband or by a family controlled corporation, also result in a deferred (or disallowed) tax-loss. As you can imagine, this can be a real nightmare for active traders who concentrate in just a few different stocks.
Once a transaction's loss is deferred because of the wash sale rule the basis of the stock currently acquired/held is adjusted upward by the amount of the deferral. The next transaction involving those shares, be it the next day or the next year, utilizes the new higher adjust tax-basis. Therefore, if the entire position is subsequently liquidated and you further remain out of the stock for the next 31 consecutive days, the entire deferred loss will generally be recognized for tax-purposes through the increase in basis used to compute the final gain or loss. But if you should re-enter the position within the 31 following days you may again find the wash sale rule comes into play. For active traders this can go on and on and on.
One unofficial "trick" to avoid some or all of the annual headache is to stop trading and holding any and all positions for a 31 consecutive day period that includes December 31st. If you do this at both the beginning and the end of any given calendar year, generally, you can just ignore the wash sale rule with relative impunity. (this isn't really a "trick", it's just "in the math" of counting days pursuant to the rule)
As is usual in the tax law, there are numerous exceptions with this "trick". If you do trade or hold a stock in either 31-day period (the one at the beginning of the year or the one at the end of the year) you will need to review that stock for the whole year to see how the wash sale effects you.
Even if you have no positions or activity at all during both 31-day periods (the one at the beginning of the year or the one at the end of the year) there are rare circumstances where the wash sale could still have some effect. For example, if (for some unrelated reason) you need to compute your income for only part of the year - then the wash sale, technically speaking, should not be ignored during the year. But if you are like most folks, this situation almost never comes up. For those who are curious - typically the need to compute your income for part of the year might arise due to death; divorce; marriage; other contractual issues; s-corp. issues; when trying to minimize or eliminate an estimated tax penalty by using the annualized income installment method; when new tax rate changes become effective in mid-year, and so on.
The good news is that Securities Traders properly electing mark-to-market under IRC §475 are not subject to the above wash sale rule on those securities covered by their mark-to-market election. i.e. any of their separate unrelated investment securities will continue to be subject to the wash sale rule.
Wash Sales and IRA's
On December 20, 2007 the IRS issued an advance copy of Rev. Rul. 2008-5, 2008-3 I.R.B. ___ (1/22/08), which applies the §1091 wash sale rules where a taxpayer sells stock or securities at a loss and then causes her IRA to purchase substantially identical stock or securities within thirty days. As a result, the loss on the sale is disallowed and the taxpayer's basis in the IRA is not increased.
Excellent Links that discuss the wash sale rule:
Some of these links include the opinions of their authors
(keep in mind that these may not be updated and could get stale):
Motley Fool, basic overview
Motley Fool, an updated version
Online Investor, basic overview
Getting Around the Wash Sale Rule with ETFs
Fairmark Press, covers many angles
CBOE, Ernst & Young, detailed explanation
CBOE, Using Options to Increase Your Clients’ After-Tax Rate of Return
Sell in regular account then buy back with your IRA account
BusinessWeek Investor 11/13/00 story of wash sale strategy's
Electronic-Traders.com has a brief but accurate description
Active Trader Magazine, Ted Tesser article
IRS broadens the definition of wash sale
SEC Administrative Proceeding against Rajan Moondra
SEC v. Kin H. Lee
SEC definition of Wash Sales
Wash Sale market manipulation
IRS publication 550, see chapter 4, pages 51 & 52 (pdf format)
IRS Code §1091 "wash sales"
IRS Code §1091 "wash sales" (old backup site)
IRS Reg. §1091 "wash sales"
IRS Code §267 "related party wash sales"
IRS Code §267 "related party wash sales" (old backup site)
There are special rules for "§1256 Contracts" which are beyond this page's discussion. §1256 includes: regulated futures contracts, foreign currency contracts, non-equity options, dealer equity options and dealer securities futures contracts. This are generally reported on IRS form 6781
A typical story from Wash-Sale Hell
> In 1996, I was an active day trader. At the end of the year, I had
> lost several thousand dollars. I'm currently being audited for that
> year and, because of the wash sale rule, the IRS wants to push my
> losses into 1997. Instead of a loss, they claim I had a capital gain
> of almost $250,000, creating a tax liability of more than $80,000. On
> top of this, they want to charge me almost $40,000 in interest,
> including interest for the 19 months it has taken for them to complete
> their review of my return!
> This seems grossly unfair to me, and I am in the process of fighting
> their determination and would like to change the wash sale rules so
> that they don't apply to active traders. If you have a horror story
> about trading and the IRS, please send me a message.
June 16, 2011
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