Don’t Get Wiped by Wash Sales
Getting a tax break when you sell a declining investment is one of the few upsides of seeing an investment underperform. So, you wouldn’t want to lose that tax break by triggering an IRS rule called a “wash sale”.
A wash sale occurs when an investor sells a security at a loss and then repurchases the same security (or a substantially identical investment) within 30 days before or after the sale.
The intention behind this rule is to discourage investors from selling securities solely for the purpose of generating a tax loss while maintaining their investment in the same or similar security. Under this rule, when wash sales are triggered the investor will carry forward the purchase price of their original investment instead of the newer purchase price.
One unique aspect of the wash sale rule is the concept of “substantially identical securities”. This refers to securities that are nearly identical in terms of their underlying holdings and characteristics. For example, selling shares of one mutual fund and buying shares of another mutual fund with a very similar investment strategy and portfolio could be considered a wash sale. The same applies to selling common stock and buying preferred stock of the same company, or selling bonds and buying new bonds with nearly identical terms. By being aware of the rules, substantially identical securities are relatively straightforward to avoid.
Interestingly, there is currently an exception on wash sale rules for cryptocurrencies. Cryptocurrencies are treated as property, not securities, by the IRS. As a result, the wash sale rule does not currently apply to crypto transactions. This means that crypto investors can sell their assets at a loss and repurchase them without waiting 30 days, allowing them to claim a tax-deductible loss while maintaining their investment. It also means that an active investor could sell a stock or fund and buy crypto to avoid wash sale. The crypto property rule might change as regulations evolve, so investors should be cautious and stay informed about any changes.
When a wash sale is triggered, you are able to add the amount of the loss back onto of the cost basis of the replacement security, helping with taxes later. It’s also important to remember that you only pay taxes on what you make. If your overall investment strategy is profitable and a portfolio manager decides to repurchase a sold security within 30 days, the impact of wash sales could be less significant in the grand scheme of the portfolio. Ideally, however, that repurchase could wait until the 31 day mark.
