The wash sale rule is one of the most misunderstood tax regulations affecting traders. Violating it can lead to unexpected tax bills and lost deductions. Understanding this rule is essential for any active trader who wants to optimize their tax situation while staying compliant with IRS regulations.
Disclaimer
This is general information, not tax advice. Consult a qualified tax professional for your specific situation.
What Is the Wash Sale Rule?
The wash sale rule is an IRS regulation that prevents taxpayers from claiming a tax loss on a security if they purchase a "substantially identical" security within 30 days before or after the sale. This creates a 61-day window (30 days before, the sale date, and 30 days after) during which you must avoid repurchasing the same or similar securities.
The rule exists to prevent investors from selling securities at a loss to claim the tax deduction while immediately buying them back to maintain their position. The IRS considers this an artificial loss that should not reduce your tax burden.
Key insight: The wash sale rule does not eliminate your loss permanently. It defers the loss by adding it to the cost basis of your replacement shares, which means you will eventually realize the loss when you sell those shares without triggering another wash sale.
The 61-Day Window Explained
The wash sale window is often misunderstood. Here is exactly how it works:
- 30 days before: If you buy shares within 30 days before selling at a loss, the loss is disallowed
- Sale date: The day you sell the security at a loss
- 30 days after: If you buy shares within 30 days after selling, the loss is disallowed
For example, if you sell stock at a loss on March 15, you cannot have purchased substantially identical securities between February 13 and April 14 to claim the loss.
What Counts as Substantially Identical?
The IRS has not provided a precise definition of "substantially identical," but here are the guidelines based on rulings and precedent:
Clearly Identical
- Same stock (e.g., selling AAPL and buying AAPL)
- Options on the same stock
- Contracts to acquire the same stock
Likely Identical
- Bonds from the same issuer with similar terms
- Preferred and common stock of the same company (case-by-case)
Generally Not Identical
- Different stocks in the same industry (selling AAPL, buying MSFT)
- Different ETFs tracking the same index (selling SPY, buying VOO) - though this is a gray area
- Mutual funds from different companies tracking similar indexes
Options and Wash Sales
Options add significant complexity to wash sale calculations. Here is how different scenarios are treated:
Buying Calls After Selling Stock at a Loss
Purchasing call options on a stock you just sold at a loss will trigger a wash sale. The call option is considered substantially identical because it gives you the right to acquire the same stock.
Selling Puts After Selling Stock at a Loss
Writing (selling) put options can also trigger a wash sale if the put is deep in the money, as it creates an obligation similar to owning the stock.
Options Expiring Worthless
If you have a loss on options that expire worthless and then buy the same stock or options within the wash sale window, the rule applies.
Key insight: Active options traders need robust tracking systems because the wash sale rule applies across all accounts, including IRAs. Your broker may not catch all wash sales, especially across different account types.
How Wash Sales Affect Your Cost Basis
When a wash sale occurs, your disallowed loss gets added to the cost basis of your replacement shares. Here is an example:
- You buy 100 shares of XYZ at $50 per share (cost basis: $5,000)
- You sell 100 shares at $40 per share (proceeds: $4,000, loss: $1,000)
- Within 30 days, you buy 100 shares at $42 per share
- Wash sale triggered: $1,000 loss is disallowed
- New cost basis: $42 + $10 (disallowed loss per share) = $52 per share
Now your cost basis is $5,200 instead of $4,200. If you later sell at $55, your taxable gain is only $300 instead of $1,300. The loss is deferred, not lost permanently.
Partial Wash Sales
Wash sales can be partial when you repurchase fewer shares than you sold. Only the portion of the loss corresponding to the repurchased shares is disallowed.
Example: You sell 200 shares at a loss of $2,000, then buy back 100 shares within the wash sale window. Only $1,000 of the loss (corresponding to 100 shares) is disallowed. You can still claim the other $1,000.
Wash Sales Across Accounts
The wash sale rule applies across all your accounts, including:
- Taxable brokerage accounts
- Traditional and Roth IRAs
- Your spouse's accounts (if filing jointly)
- Accounts at different brokerages
This is where many traders get caught. Your broker reports wash sales within a single account, but they cannot track purchases in your IRA or at another brokerage. You are responsible for tracking these cross-account wash sales.
IRA Wash Sale Trap
If you sell at a loss in a taxable account and buy the same security in your IRA within 30 days, the loss is permanently disallowed. Unlike regular wash sales, you cannot add the loss to the IRA cost basis because IRAs do not have cost basis for tax purposes.
Strategies to Avoid Wash Sales
Here are legitimate strategies to harvest tax losses while avoiding wash sale problems:
Wait 31 Days
The simplest approach is to wait 31 days before repurchasing. The downside is market exposure risk during this period.
Buy Similar but Not Identical Securities
Instead of repurchasing the exact same security, consider buying a similar one:
- Sell individual stock, buy a sector ETF
- Sell one S&P 500 ETF, buy another (SPY to IVV)
- Sell one bond, buy a similar bond from a different issuer
Double Up Before Selling
Buy additional shares, wait 31 days, then sell the original loss shares. This maintains your position throughout but requires additional capital.
Record Keeping for Wash Sales
Proper documentation is crucial for wash sale tracking:
- Track all purchases and sales with dates across all accounts
- Monitor the 61-day window for each loss sale
- Calculate adjusted cost basis for replacement shares
- Keep records for at least seven years
- Review your 1099-B for broker-reported wash sales
Track Wash Sales Automatically
Pro Trader Dashboard monitors your trades and helps identify potential wash sale situations across all your positions.
What Happens If You Ignore Wash Sales?
Ignoring wash sales can lead to serious problems:
- IRS audit: Misreported wash sales can trigger an audit
- Penalties and interest: You may owe additional taxes plus penalties
- Amended returns: You may need to file amended returns for multiple years
Summary
The wash sale rule is a critical tax regulation that every active trader must understand. Remember these key points: the rule creates a 61-day window around loss sales, it applies across all your accounts, options can trigger wash sales, and IRA purchases can permanently disallow losses. While the rule can be frustrating, proper planning and tracking allow you to harvest tax losses legally while staying compliant.
Your disallowed losses are not gone forever - they are added to your replacement shares' cost basis. With good record keeping and strategic planning, you can minimize wash sale impacts while maximizing legitimate tax deductions.
Learn more: tax loss harvesting strategies and capital gains tax guide.