You can take advantage of legitimate tax breaks without risking a run-in with the IRS if you have a clear understanding of the ins and outs of wash sales and the wash-sale rule. Continue reading to find out how the wash sale rule can benefit you.
The wash sale rule forbids an investor from claiming a tax deduction if they sell an investment at a loss then buy it back again within 30 days of the sale, or if the investments are substantially equivalent.
It's a full 61 days before you (or your spouse or a corporation you control) can buy an investment that's the same or similar enough in the eyes of the IRS to the one you just sold. This includes the day you sell your investment. A wash sale could invalidate any losses you incurred from the deal.
Say you buy 100 shares of XYZ stock for $10 each for a total of $1,000. After a year, the stock starts to go down, so you sell your 100 shares for $8 each, which is a loss of $200. After three weeks, each XYZ share sells for $6. You decide that this price is too good to pass up, so you spend $600 to buy back the 100 shares. This leads to a wash sale.
You can't write off the $200 loss on your taxes for this year. Instead, the $200 loss is added to the price at which you bought the stock again. So, the replacement stock you bought for $600 now has a cost basis of $800. If you later sell that stock for $1,000, your taxable gain will be $200 instead of $400. Since you've owned XYZ for a year, you'll get a long-term capital gain even if you sell it after only a few months.
In simple terms, the wash sale rule is intended to stop investors with bad intentions from taking advantage of temporary drops in the value of an investment to get a tax break and then repurchasing the same investment to lock in what could be a better cost basis, which will be used to figure taxes on future gains.
The wash sale rule applies to all kinds of identical or nearly similar investments that a person, their spouse, or a corporation they control sells and buys within 61 days.
It's challenging to unintentionally violate the wash sale regulation. The wash sale rule often only applies to stock that originates from the same business, according to the IRS. In order to conduct a wash sale, you would have to sell Company 1 stock and then repurchase the shares. Even though they are in the same business, you should not have an issue if you purchased stock in Company 2 instead.
However, when it comes to mutual funds and exchange-traded funds, things might become a little bit more complicated (ETFs). You cannot, for example, sell an index fund from one company and then acquire an index fund from a different company that tracks the same index or even one that contains the majority of the same companies. The wash sale rule applies to all of your different financial accounts, from a taxable brokerage account to your 401(k).
You cannot sell an investment at a loss in one account and then repurchase it in another account, such as an IRA (IRA). As both accounts are owned by you, this would prevent the loss from being exploited.
Related: Understanding Wash Sale Rules Is Crucial for Crypto Traders
Whether on purpose or accidentally, if you violate the wash sale rule, the IRS will prevent you from deducting that loss from your taxes in the year it occurs or, if it's significant enough, in years to come. You might wind up owing more taxes than you anticipated if you were banking on that to offset your capital gains or lower your taxable income. That can seriously hinder the tax-loss harvesting plan of some people.
However, you might still reap some rewards from your wash sale. You can multiply your loss by the price it would have cost to buy the same or nearly equivalent investment again. This increases your cost basis, which could help you save money on capital gains tax down the road. It could also allow you to deduct a bigger loss if you ever decide to sell the investment at a loss.
The IRS defines stock that comes from the same corporation, or one that has been reorganized, as “substantially identical” holdings. Knowing how to identify these stocks can help you avoid the wash sale rule. In general, if you're worried about getting hit with a wash sale, you can prevent it by doing the following:
The best strategy to prevent a wash sale is to wait the full 30 days after selling your investment before purchasing the same or a comparable investment. Additionally, you should confirm that you didn't purchase a comparable or identical investment on the day you sold it or within the 30 days before it.
Invest in a similar, but not "substantially identical" investment by using tax loss harvesting, which entails selling one stock to offset the profits of another one. These can be industry-specific ETFs or mutual funds. To be extra cautious, investing in a totally other industry or sector will guarantee that you will not violate the wash sale rule.
TIP: It's usually not a good idea to sell an investment for tax reasons, even if it's losing money. A plan for investing must also be in place to back up the sale. Don't let taxes get in the way of your investment decisions.
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It goes without saying, it is always best to carefully plan your investments. If investors panic sell and then repurchase the same investment after the market starts to recover, they may unintentionally violate the wash sale rule if they are unprepared for short-term market downturns.
Making the greatest financial and tax decisions for both good and bad times can be aided by having a long-term investment strategy that you stick to, even during market downturns.
Only capital losses fall under the wash sale rule. The wash rule would not apply to exchanges in which you sold stock at a profit and then engaged in a subsequent transaction involving the same stock or a stock that is nearly comparable.
Cryptocurrency is not technically subject to the wash sale regulation because it is not a stock. This means that cryptocurrency owners have the option to sell their coins at a loss, claim a tax deduction for that loss, and then buy the exact same cryptocurrency again right afterwards.
However, recent congressional plans would fix this loophole as soon as January 1, 2022, at the latest. If you intend to claim losses from cryptocurrencies in 2022 and beyond, be sure to first consult a tax professional because these are not yet finalized and most likely would not be retroactive to 2021.
Talk things over with your tax advisor to come up with a strategy that will benefit you the most.
Being audited is comparable to being struck by lightning. You don't want to practice pole vaulting in a thunderstorm just because it's unlikely. Making sure your books are accurate and your taxes are filed on time is one of the best ways to keep your head down during tax season. Check out Vincere's take on tax season!
This post is just for informational purposes and is not meant to be legal, business, or tax advice. Regarding the matters discussed in this post, each individual should consult his or her own attorney, business advisor, or tax advisor. Vincere accepts no responsibility for actions taken in reliance on the information contained in this document.
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