An Investor’s Guide to Wash Sale Rules and Tax Loss Harvesting
Do you know what a wash sale is? How about tax loss harvesting? If you’re an investor, you’ll want to learn and commit these terms to memory. Why? Because these terms can help you save significant money on your taxes. No one likes losing investments, but it’s an unavoidable part of the wealth building process. But did you know that those unpleasant losses can transform into something valuable when tax time rolls around? They can if you learn to employ the right strategies.
In this article, we’ll explain how you can transform losses into tax savings. Of course, remember to consult your tax professional for advice specific to your situation. This article is neither tax nor legal advice.
What is Tax Loss Harvesting?
Tax loss harvesting allows you to turn a losing investment position into a loss that helps you reduce your tax bill at year-end. To do it, you simply need to lock in a loss by selling the investment position. That sale creates a tax loss that then offsets gains you realized from other investments.
If the loss exceeds your realized gains for the year, that loss can offset up to $3,000 of taxable earned income. Then, any loss you don’t use fully is carried over to the following year, so you can use it up in the future. If you incur a more significant loss, you can roll it over multiple years until it is used up.
With this technique, you get to write off losses against your gains. That’s not a bad thing, of course, but bottom line…you’ve still lost money.
Put Those Losses to Work
Fortunately…there’s another step that can turn this “better than nothing” loss into something that’s actually a win for your finances. However, that requires following some regulations, including the wash sale rule, so let’s define that first.
What is the Wash Sale Rule?
The IRS prohibits wash sales, meaning you can’t simply sell a stock and claim a taxable loss, then buy it right back. To stop investors from abusing this strategy, the IRS requires you to wait 30 days to buy that same stock, ETF, or mutual fund back. Further, you are prohibited from replacing that investment with a “substantially identical one” during that same time frame.
If you violate this rule, you create what’s called a wash sale. And you don’t get to write off that loss.
That 30 day period looks before the sale, as well. For example, let’s say you had a loss in 100 shares of IBM stock. While you have to wait 30 days to buy it back, you also can’t front-run your sale by buying another 100 shares a week before selling your other shares.
The wash sale rule also extends to your other accounts, and usually to your spouse’s accounts as well. So you can’t sell a stock in your taxable account, then immediately buy it in your IRA account. Or you can’t sell it but then have your spouse establish a position during those 30 days.
If you do any of these things within that 30 day time period, you create a wash sale. That means you lose the tax loss.
Enter the Tax Swap
There is a way to have your cake and eat it too, however. As long as you don’t buy that particular stock or fund back, you can buy a similar but not identical position without violating the wash sale rules.
This tax swap allows you to regain exposure to that sector or industry, so you don’t get left behind in a broad rebound or recovery.
As an example, let’s say you want to sell Wells Fargo Bank shares that you are holding at a loss. While you can’t buy that exact stock back, you can buy a competitor like Bank of America. Or, you can buy a bank stock ETF or mutual fund.
After the 30 day period expires, you are free to either keep the current position or buy back your original holding.
As you can probably see, this allows you to create a taxable loss to lower your income taxes while maintaining a similar position in the market.
Following the rules
As your income and tax liability grow, this becomes an increasingly valuable strategy. And even if you don’t have any gains this year, losses captured with this strategy can be used to offset other income and future gains.
But one thing to be aware of: the rules are very strict. You should work with your tax professional to ensure that you handle the process correctly.
Does the wash sale rule apply to gains?
No, any time you sell a stock for a profit in a taxable account, you’ll get a capital gain. If you want to repurchase it the next day, it’s no problem for the IRS since they will still get to tax your capital gain from your recent sale.
Does the wash sale rule apply to cryptocurrency transactions?
Interestingly enough, as of the date of this article, it does not. So (in theory) if you hold a cryptocurrency position at a loss, you can sell it, claim the taxable loss, and then immediately repurchase it.
So if you have losses in Bitcoin, Ethereum, Dogecoin, or other crypto tokens, you have a unique opportunity.
But beware, this is likely to change in the future. Also, this only pertains to true cryptocurrencies. If you’re trading cryptocurrency equities (such as RIOT or MARA) or ETFs (such as GBTC), wash sale rules will still apply.
Does the wash sale rule apply to options, futures, or currency trades?
The wash sale rule does apply to option contracts to buy or sell stocks or other securities.
According to IRS Publication 550, the wash sale rule does not apply to commodity futures contracts and foreign currencies sales.
What are the rules on wash sale replacement shares?
With individual stocks, the IRS rules are straightforward: securities issued by different corporations are not considered “substantially identical.”
But those involving the same corporation usually are. So, if you sell a stock, then immediately replace that position with options on the same stock, that will usually trigger a wash sale.
There is some substantial gray area, however, when you get into securities like index funds. For example, let’s say you sell an S & P 500 index fund but buy one back that is similar but sold by a different fund company. There are no clear rules on this, so you may want to be careful here.
Beware dividend reinvestments
There are a few other ways to run afoul of wash sales rules. One common way that can be easily overlooked is when you participate in an automatic dividend reinvestment plan. If a dividend is paid out within 30 days of your sale, even a tiny reinvestment will, unfortunately, trigger a wash sale and disallow your taxable loss.
What happens when you trigger a wash sale?
Triggering a wash sale by mistake is not the end of the world. There’s no penalty for creating a wash sale by violating the rules. However, you don’t get to claim your loss in the current year. Or you may end up just getting to realize a partial taxable loss if you bought back fewer shares than you sold.
You can put any disallowed loss to use at a later time, fortunately. Instead of a current year taxable loss, your basis in the investment will be increased by the amount of the loss. So you will eventually get credit for the loss when you sell the shares at a later date.
Wash sale rules only apply to taxable accounts
One thing to note is that tax loss harvesting and wash sales apply only in taxable accounts. Because gains in retirement accounts are tax-deferred, there is no tax impact until you withdraw funds. Or in the case of Roth accounts, you won’t owe any more taxes if you follow withdrawal rules.
Putting tax loss harvesting into action
As you can probably see, tax loss harvesting can be a powerful tool to help you lower your taxes. But the key is to plan in advance and do it consistently.
If you have a financial professional who handles your investments, be sure to ask if and how often they are harvesting tax losses on your behalf.
If you manage your own accounts, set a reminder to look at this periodically, such as quarterly. That way, you’ll have time to look for opportunities to sell and replace investments that have fallen in value.
If you’re a cryptocurrency investor, you may want to use this opportunity to seek tax loss harvesting without wash sale limits since that won’t likely last too long.
However you decide to implement this, be sure to work with your tax professional and keep careful records. If the IRS ever questions a sale, you’ll always want complete documentation to help substantiate your calculations.