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The wash-sale rule is an IRS rule designed to prevent investors from creating artificial losses that can reduce their tax bills. While the rule makes sense from a practical standpoint, it can sometimes be tricky for day traders to navigate. In this article, we’ll cover everything day traders need to know about the wash-sale rule and explain how you can work around it.
What is the Wash-sale Rule?
The wash-sale rule is an IRS rule that prevents traders and investors from claiming a capital loss for tax purposes if they re-enter a position within 30 days of claiming the loss. That is, if you sell a stock for a loss and then buy it back a few days later, you cannot claim a tax deduction on the loss.
The best way to understand the wash-sale rule is with an example. Say you buy $5,000 worth of a stock and then it loses value. You sell your stock for $3,000 on June 1, giving you a capital loss of $2,000 that you could use as a tax deduction. However, if you repurchase the same stock on June 15, you will trigger the wash-sale rule, and you can no longer claim the $2,000 capital loss for tax purposes.
Importantly, the wash-sale rule applies for 30 days after a sale and 30 days before a sale. So, if you have a long-held position and buy shares within 30 days of selling some of your long-held shares for a loss, that also triggers the wash-sale rule.
Finally, the wash-sale rule applies on a one-to-one share basis. If you sell 200 shares of a stock and repurchase 100 shares within 30 days, the wash-sale rule only applies to 100 shares.
Purpose of the Wash-Sale Rule
The wash-sale rule is designed to prevent investors from creating artificial capital losses while mostly maintaining their position in a stock. Without the wash-sale rule, investors could sell and then repurchase shares anytime the price drops to generate quick capital losses, thus reducing their tax bill at the end of the year.
Because of the wash-sale rule, investors who sell a stock have to wait at least 30 days before repurchasing it if they want to claim a capital loss.
Why the Wash-Sale Rule Creates Issues for Traders
The wash-sale rule was created with investors in mind, but it also applies to the majority of day and swing traders. Although day traders are legitimately selling and repurchasing stocks as part of their trading strategies – as opposed to trying to avoid taxes – they still have to keep the wash-sale rule in mind. This is one of the cons of day trading.
If a day trader triggers the wash-sale rule, they could end up in a situation where a large loss is not tax deductible. The result is that the effective size of the loss is even greater since traders have to deal with both the loss and taxes on the position.
The good news is that losses from wash sales can be added to the cost basis for a new position. Say a trader buys 100 shares of a stock at $50, then sells those shares for $45. If they repurchase 100 shares for $47 a few days later, their new cost basis is $5,200 – $4,700 (the cost of the new position) plus $500 (the wash sale capital loss).
Types of Trades That Can Trigger a Wash Sale
Selling and repurchasing shares of the same stock can trigger the wash-sale rule, but there are also other types of trades that can trigger this rule. The wash-sale rule applies to ETFs, options, and most other securities.
In addition, selling a security and buying a substantially similar security within 30 days can trigger the wash-sale rule. So, a trader could trigger the wash-sale rule by selling one oil ETF and buying another one a few days later. The rules around what funds are similar enough to trigger a wash sale are ambiguous. However, in most cases, buying and selling shares of different individual companies will not trigger the wash-sale rule even if the companies are in the same industry.
What Traders can do about the Wash-Sale Rule
Most of the time, traders simply need to be aware of the wash-sale rule’s existence and understand when it applies to their trades. Unless you are planning to write off a major loss, it’s usually not worth changing your trading strategy for tax reasons.
If you do plan to write off a large loss, it’s important to recognize when the wash-rule applies and how much triggering it could cost you. It’s a good idea to talk to an accountant or tax expert to find out what your options are.
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Another option for day traders is to take the mark-to-market tax election. This is a special tax classification for day traders that allows them to write off capital losses as business expenses. Switching to mark-to-market trading can be complex and must be done ahead of time. Generally speaking, the IRS only approves mark-to-market tax elections for individuals who day trade as a full-time job.
Conclusion: Wash-Sale Rule
The wash-sale rule prevents traders from claiming a capital loss for tax purposes when selling and repurchasing a stock within a 30-day period. Day traders may trigger the wash-sale rule frequently, so it’s important to understand when it applies and what the tax implications may be. For most traders, in most cases, it does not make sense to change your trading strategy to avoid triggering the wash-sale rule, but traders should be aware of the rules that may impact their bottom lines.
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Image and article originally from daytradereview.com. Read the original article here.