WATCH OUT FOR THE WASH SALE RULE THIS TAX YEAR

The first quarter of 2023 was wonderful compared to what investors faced in 2022. But markets are still far from record highs, and many investors are still looking for ways to make the best of a bad situation. Some may be looking into tax-loss harvesting, selling securities at a loss to offset gains in other income areas. If tax-loss harvesting is part of your investment strategy, be aware of the Wash-Sale Rule. This IRS rule may not cripple your strategy but can put a kink in your plans. Here’s what it is and how to avoid it.

What is a wash sale?

A wash sale occurs when a person sells or trades an investment security for a loss and buys a similar security within 30 days before or after that sale.

A wash sale also happens if a person sells a security at a loss and their spouse or a company they control purchases a similar security 30 days before or after the sale.

So, what’s the rule?

The Wash-Sale Rule states that if a wash-sale occurs, that individual cannot deduct the loss on their taxes. The IRS does not want investors creating artificial losses for tax breaks. However, the amount of that loss is added to the cost of the purchase that started the wash-sale. If that security is also sold at a loss, it can be taken as a tax deduction. So, a wash-sale may not prevent taking a tax deduction on the original sale, but it may defer it.

There is one caveat to that. Suppose someone sells a security at a loss in a non-retirement account and purchases a similar one for their IRA. In that case, they cannot claim the loss, nor can it be deferred.

Confused yet? Here’s an example to help.

A Wash-Sale Rule example

Suppose you buy 50 shares of Stock A for $1,000 on April 1st. Then, on May 1st, you sell all of it for $800 and realize a capital loss of $200 for a tax deduction. On May 15th, you purchase 50 shares of the same stock to regain your position. No deduction will occur. Instead, the loss is added to the second purchase. It will adjust the cost basis of the stock and be used to determine your gain or loss when sold.

So, a wash-sale isn’t illegal, and there’s no specific penalty. But there are consequences regarding a potentially higher cost basis for the new transaction. And, at best, your tax loss harvesting effort is deferred. At worst, it is negated.

The Bottom Line

Like so many financial situations, nuances and special situations surround the Wash-Sale Rule, depending on your circumstances. So, it’s always wise to speak with a CPA and a fiduciary financial advisor if you have questions. But if tax loss harvesting is part of your investment strategy, steer clear of wash sales. The best thing that happens is a delay in your plans.