The wash sale rule is one of the most important tax rules that every active trader needs to understand. Violating this rule can result in disallowed losses, unexpected tax bills, and headaches during tax season. In this comprehensive guide, we will explain exactly what the wash sale rule is and how to avoid triggering it.
What is the Wash Sale Rule?
The wash sale rule is an IRS regulation that prevents taxpayers from claiming a tax deduction on a security sold at a loss if they purchase a substantially identical security within 30 days before or after the sale. The rule applies to stocks, bonds, mutual funds, ETFs, and options.
The 61-Day Window: The wash sale rule applies to purchases made 30 days before the sale, the day of the sale, and 30 days after the sale. This creates a 61-day window where you must avoid buying substantially identical securities.
How the Wash Sale Rule Works
When you trigger a wash sale, the loss is not permanently lost. Instead, it gets added to the cost basis of the replacement shares. This defers the loss until you eventually sell those replacement shares without triggering another wash sale.
Example of a Wash Sale
You bought 100 shares of XYZ stock for $5,000. The stock drops and you sell all shares for $3,000, creating a $2,000 loss.
- Original purchase: $5,000 (100 shares at $50)
- Sale price: $3,000 (100 shares at $30)
- Loss: $2,000
If you buy 100 shares of XYZ within 30 days at $32 per share ($3,200), the wash sale rule is triggered:
- Your $2,000 loss is disallowed for this tax year
- The new shares have a cost basis of $5,200 ($3,200 + $2,000)
- You can claim the loss when you sell these new shares (if no wash sale occurs)
What Triggers a Wash Sale?
Several actions can trigger the wash sale rule:
- Buying the same stock: Purchasing identical shares within the 61-day window
- Buying options: Purchasing call options or selling put options on the same security
- Buying in another account: Purchasing in your IRA, spouse's account, or a corporation you control
- Reinvesting dividends: Automatic dividend reinvestment can trigger wash sales
- Substantially identical securities: Buying a nearly identical ETF or mutual fund
What Does NOT Trigger a Wash Sale?
The wash sale rule has limits. These actions typically do not trigger a wash sale:
- Waiting 31 days: Buying the same security after 31 days have passed
- Buying a different security: Purchasing a different company's stock
- Buying a different sector ETF: Switching from one index fund to another that tracks a different index
- Gains: The rule only applies to losses, not gains
Substantially Identical Securities
The IRS does not provide a precise definition of "substantially identical," which creates some gray areas. Here are general guidelines:
Generally Substantially Identical
- Same company's stock (AAPL for AAPL)
- Convertible securities of the same company
- Options on the same underlying stock
Generally NOT Substantially Identical
- Different company's stock in the same sector
- S&P 500 ETF from one provider vs. another (debatable)
- Preferred stock vs. common stock (usually)
- Bonds with different maturities or issuers
Wash Sales and Options
Options add complexity to the wash sale rule. Here is what you need to know:
- Buying calls: Purchasing call options on a stock you sold at a loss can trigger a wash sale
- Selling puts: Selling put options can also trigger wash sales since it creates an obligation to buy
- Deep in-the-money options: These are more likely to be considered substantially identical
- Options on the same underlying: Generally trigger wash sales with the underlying stock
Strategies to Avoid Wash Sales
Here are practical strategies to harvest losses without triggering wash sales:
- Wait 31 days: The simplest approach is to wait 31 days before repurchasing
- Buy a similar but different security: Replace with a different ETF or stock in the same sector
- Double up strategy: Buy additional shares, wait 31 days, then sell the original shares at a loss
- Use tax-loss harvesting pairs: Identify pairs of similar but not identical securities you can swap between
Tax-Loss Harvesting Pair Example
You own Vanguard S&P 500 ETF (VOO) at a loss. To harvest the loss:
- Sell VOO at a loss
- Immediately buy iShares S&P 500 ETF (IVV) or SPDR S&P 500 ETF (SPY)
- Maintain market exposure while claiming the loss
- After 31 days, you can switch back to VOO if desired
Note: The IRS has not definitively ruled on whether these are substantially identical. Consult a tax professional.
Wash Sales Across Multiple Accounts
A common misconception is that wash sales only apply within the same account. The wash sale rule applies across:
- All your brokerage accounts (taxable and retirement)
- Your spouse's accounts (if filing jointly)
- Accounts of entities you control (corporations, trusts)
IRA Trap: If you sell a stock at a loss in your taxable account and buy it within 30 days in your IRA, the loss is disallowed AND you cannot add it to the IRA's cost basis. The loss is permanently lost.
Tracking Wash Sales
Your broker is required to track and report wash sales on your 1099-B, but only for transactions within that account. You are responsible for tracking wash sales across multiple accounts and between your accounts and your spouse's accounts.
Automatically Track Your Wash Sales
Pro Trader Dashboard automatically identifies wash sales across all your trades, helping you avoid unexpected tax surprises and optimize your tax-loss harvesting strategy.
Common Wash Sale Mistakes
Avoid these common errors that trigger unintended wash sales:
- Forgetting about dividend reinvestment: Automatic DRIP purchases can trigger wash sales
- Buying in your IRA: Purchases in retirement accounts can disallow taxable losses
- Year-end trading: Selling in December and buying in January still triggers wash sales
- Options activity: Opening option positions on stocks you sold at a loss
Summary
The wash sale rule prevents you from claiming a tax loss if you buy substantially identical securities within 30 days before or after the sale. While the rule can be frustrating for active traders, understanding how it works allows you to plan your tax-loss harvesting strategy effectively. Remember that disallowed losses are not lost forever; they are added to your cost basis and can be claimed when you eventually sell without triggering another wash sale.
Ready to learn more about tax-efficient trading? Check out our guide on tax-loss harvesting strategies or learn about short-term capital gains taxes.