Wash Sale: Definition, How It Works, and Purpose

What Is a Wash Sale?

A wash sale is a transaction in which an investor sells or trades a security at a loss and purchases "a substantially similar one" 30 days before or 30 days after the sale. This is a rule enacted by the Internal Revenue Service (IRS) to prevent investors from using capital losses to their advantage at tax time.

The wash sale rule applies to stocks, contracts, options, and all other types of securities and trading.

Understanding a Wash Sale

Many countries' tax laws allow investors to claim a specific amount of capital losses on their taxes as an income reduction. In the U.S., you can claim up to $3,000 or your total net loss, whichever is less. If you have more than $3,000 in capital losses, you can carry the additional loss forward into the following years.

The ability to carryover losses led to investors inventing a loophole where they would plan to sell a losing security and buy it again within a short period. This allowed them to claim a capital loss and use that loss to mitigate tax liabilities.

To prevent the abuse of this incentive, the Internal Revenue Service (IRS) instituted the Wash Sale Rule in the U.S. (In the U.K., the practice is known as bed-and-breakfasting, and the tax rules in the U.K. have an implementation similar to the Wash Sale Rule). The law states that if an investor buys a security within 30 days before or after selling it, any losses made from that sale cannot be counted against reported income. This effectively removes the incentive to do a short-term wash sale.

How It Works

Generally, a wash sale has three parts.

1. An investor notices they are in a losing position, so they close it by selling the stock or exiting a trading position.
2. The sale allows them to take a loss that they can legally claim on their tax returns as a reduction of their earnings for that year, which reduces their total tax liability.
3. The investor will look to purchase the security at or below the price at which they sold it—if the purchase occurred 30 days before or after the sale, it is considered a wash sale, and the loss cannot be claimed.

Wash Sale Example

Assume an investor has a $15,000 capital gain from the sale of ABC stock. They fall in the highest tax bracket and must pay a 20% capital gains tax of $3,000. But let’s say they sold XYZ security for a loss of $7,000. The net capital gain for tax purposes would be $15,000 - $7,000 = $8,000, which means they’ll have to pay only $1,600 in capital gains tax. Notice how the realized loss on XYZ reduces the gain on ABC, reducing the investor’s tax bill.

However, if the investor repurchases XYZ stock—or a stock substantially identical to XYZ—within 30 days of the sale, the above transaction is counted as a wash sale, and the loss is not allowed to offset any gains.

Special Considerations

The IRS does not ordinarily consider bonds and preferred stock of an issuing company to be substantially identical to the company’s common stock. However, there may be circumstances where preferred stock, for example, may be considered substantially identical to the common stock.

This would be the case if the preferred stock is convertible into common stock without any restriction, has the same voting rights as the common stock, and trades at a price close to the conversion ratio.

Reporting a Wash Sale Loss

The good news is that any loss realized on a wash sale is not entirely lost. Instead, the loss can be applied to the cost basis of the most recently purchased substantially identical security. Not only does this addition increase the cost basis of the purchased securities, but it also reduces the size of any future taxable gains as a result.

Thus, the investor still receives credit for those losses, but at a later time. Also, the holding period of the wash sale securities is added to the holding period of the repurchased securities, which increases an investor’s odds of qualifying for the 15% favorable tax rate on long-term capital gains.

The Bottom Line

A wash sale occurs when an investor sells a security at a loss and then purchases the same or a substantially similar security within 30 days, before or after the transaction. This rule is designed to prevent investors from claiming capital losses as tax deductions if they re-enter a similar position too quickly. While not illegal, wash sales have negative tax implications: losses from such sales cannot be used to offset gains in the same tax year. However, these losses can be added to the cost basis of the newly purchased security, affecting future gains. This rule is relevant to all types of securities and trading, and it's particularly significant for day traders and investors looking to use capital losses to mitigate tax liabilities. Understanding and navigating the wash sale rule is crucial for effective tax planning and investment strategy.

Correction—Oct. 14, 2022: A previous version of this article misleadingly stated that a wash sale occurred when selling a security at a loss for a tax benefit. It also incorrectly stated that an investor could not purchase the same or similar security within the 60-day window of 30 days before or 30 days after selling it.