Wash Sale

Definition of Wash Sale

A wash sale is a transaction that occurs when an investor sells a security at a loss and repurchases the same security, or a substantially identical one, within a 30-day period before or after the sale. The purpose of this practice is often to create a tax deduction for the loss while maintaining an investment in the security.

Detailed Explanation of Wash Sale

• Purpose: Investors may engage in wash sales primarily to create tax benefits by realizing losses to offset capital gains. This can lower their tax liability.
• IRS Regulations: The Internal Revenue Service (IRS) disallows the deduction of the losses incurred from wash sales. If the sale is deemed a wash, the loss is added to the cost basis of the repurchased security, thus deferring the tax benefit.
• Identification of Substantial Identity: A security is considered substantially identical if it falls within certain classifications, such as options or warrants of the same stock, or different classes of the same stock.
• Timeframe: The critical period for a wash sale is 30 days before or after the sale date. This means that transactions on either side of the sale can trigger a wash sale status.

Example of a Wash Sale

Let’s consider an investor, Alice, who owns shares of Company XYZ.

1. Alice purchased 100 shares of Company XYZ at $50 each, totaling $5,000.
2. Due to market conditions, the price of XYZ shares drops to $40.
3. Alice sells the shares, realizing a $1,000 loss ($5,000 – $4,000).
4. Within 20 days, Alice decides to buy back 100 shares of Company XYZ at $40 each.

Since Alice sold and then repurchased the same stock within 30 days, this transaction is classified as a wash sale.

Calculations Relevant to a Wash Sale

When a wash sale occurs, the $1,000 loss that Alice realized cannot be deducted for tax purposes. Instead, this loss will adjust the cost basis of her new shares.

– Original Cost Basis: $5,000 (100 shares at $50)
– Sale Proceeds: $4,000 (100 shares sold at $40)
– Loss Realized: $1,000
– New Purchase: 100 shares at $40 (total $4,000)

For tax reporting, Alice’s adjusted cost basis for the repurchased shares will be:
– Adjusted Cost Basis = New Purchase Cost + Disallowed Loss
– Adjusted Cost Basis = $4,000 + $1,000 = $5,000

Now, in future transactions involving these shares, Alice will use an adjusted cost basis of $5,000 rather than $4,000, meaning the loss can potentially be realized in a future transaction if she sells without triggering a wash sale again.