In an ideal world all of your investments would gain 10% per year indefinitely. A nice, solid source of growth that you could throw as much investment money as you wanted at.
Unfortunately we all know that is not the case; investments gain and fall. Thankfully when we invest in stocks, ETFs, mutual funds, and bond investments we can get a bit of a tax break if we incur an investment loss. However, as with any tax deduction, we have to be careful not to make a mistake that results in our loss of that deduction. A common example is the wash sale rule.
What is the Wash Sale Rule?
The wash rule is an IRS rule that prevents an investor from selling an investment at a loss today, deducting that loss, and reinvesting in the same investment tomorrow. It is a limiting period of time where you cannot reinvest in the same or substantially similar investment.
The period of time you must wait to reinvest is 30 days from when you sell the investment. If you repurchase the investment or one very similar to it, you will lose the ability to deduct the loss no matter what price you repurchased the shares at.
This is the basic understanding of the wash rule. What you may not know is the rule is much more complicated than that.
How the Wash Sale Rules Really Works for Investments
Here are some of the specifics on how the wash sale rule applies to selling investments at a loss and repurchasing similar shares in the future.
30 Day Wash Sale Rule
Most people understand the wash sale to mean you have to wait 30 days after the sale of a security before repurchasing a substantially similar investment. That is only part of the rule.
The wash rule is actually 61 days: the day of the sale, 30 days after the sale, and 30 days before the sale.
How it works is best seen through an example.
Let’s say you buy 50 shares of ABC Company at $30 per share today. Next week, you buy 25 more shares because you really like the company. Thirty one days after your initial purchase you sell your original 50 shares at $25 per share, a loss of $5 per share. You claim this loss on your your taxes, and much to your surprise the IRS says it doesn’t count as a wash sale. Why? Because you purchased shares within 30 days before the sale of the stock.
What is a Substantially Identical Security?
This is where things can be a bit tricky.
Obviously, you can’t sell shares in ABC Company and buy ABC company within the 61 day period without hitting the wash sale rules. But what about similar companies? Can you sell Exxon Mobile and purchase shares of Chevron? Although the companies are similar, they should not be considered substantially similar because although they are in the same industry one could be having a banner year and the other dealing with a large oil spill.
Things get even more tricky when it comes to ETFs and mutual funds that focus on a specific index. Low cost index investments follow the exact same set of investments, so it could be argued they are substantially similar. If you sell Vanguard’s S&P 500 Index Fund (VFINX) and buy Fidelity’s Spartan 500 Index Fund (FUSEX) does the wash rule apply? Unfortunately the IRS regulations aren’t specific down to individual investments, and the wording isn’t 100% clear. Be cautious.
Fairmark Press offers a very detailed breakdown of several different scenarios that involve the wash sale rule for investments. If you need further guidance, consult with an investment advisor or professional tax advisor. The added expense is well worth avoiding an audit!