The Broad Reach of the Wash-Sale Rule

Overview

When stock values decline, an investor loses money.  But the tax law does not allow that loss to be claimed until the investor sells the stock.  The investor can’t sell stock at a loss and simply turn around shortly after the sale and buy back substantially identical stock or securities and get to recognize the loss.  However, if an investor sells stock at a gain and buys back identical stocks (or securities), the gain is not disallowed.  The government wins in either situation. The rule barring the loss deduction in such a situation is known as the “wash sale” rule. 

The wash sale rule can apply in situations involving transactions other than simply stock or securities.  It can also apply when “related parties” are involved. 

The wash-sale rule.  That’s the focus of today’s post.

The Wash-Sale Rule

An investor often prefers to time deductions on investments by claiming then when they can get the greatest benefit.  That might include a situation where a loss is desired to be deducted and the stock be retained because the investor thinks that the stock value will increase again.  So, the idea might to sell the stock and then turn around and immediately buy it back.  But, that’s where I.R.C. §1091 applies.  That Code sections disallows a loss deduction incurred on the sale or other disposition of stock or securities where it appears that, within a period beginning 30 days before the date of such sale or disposition and ending 30 days after such date, the taxpayer has acquired (by purchase or by an exchange on which the entire amount of gain or loss was recognized by law), or has entered into a contract or option so to acquire, substantially identical stock or securities. The only exception is if the taxpayer is a dealer in stock or securities and the loss is sustained in a transaction made in the ordinary course of that business. Thus, the rule applies only to losses and bars a taxpayer from wiping out a gain from a sale by buying the same stock back within 30 days. 

As is noted in the statute, for the wash-sale rule to be triggered, the stocks or securities must truly be “substantially identical.” Stocks or securities issued by one corporation are not considered substantially identical to stocks or securities of another.  Are mutual funds caught by the rule?  The IRS basically leaves that an open question subject to the facts and circumstances of the situation.  But, selling one fund and buying a similar fund within 30 probably should be avoided.  In addition, a “related party” rule can also come into play if a spouse or other “related party” such as the taxpayer’s controlled corporation is used to try to avoid the application of the rule. 

Consequences.  As can be discerned from the above commentary, the wash-sale period for any sale at a loss consists of 61 calendar days: the day of the sale, the 30 days before the sale and the 30 days after the sale.  The wash sale rule has three consequences: (1) denial of the deductibility of the loss; (2) the amount of the disallowed loss is added to the basis of the replacement stock (which means that when the replacement stock is sold, the disallowed loss will either reduce gain or increase loss on the transaction); and (3) the taxpayer’s holding period for the replacement stock includes the holding period of the stock that was sold.  This last rule prevents a taxpayer from converting a long-term loss into a short-term loss, which can produce a rather harsh result.  In general, a taxpayer receives more tax savings from a short-term loss than a long-term loss.

Basis adjustment rule.  The basis adjustment rule has the effect of preserving the benefit of the disallowed loss – the taxpayer will receive the benefit on a future sale of the replacement stock.

Example:  In the mid-1990s, Sam bought 100 shares of ABC, Inc. at $40 per share.  The stock declined to $15 per share, and Sam sold the stock in 2000 to take the loss deduction.  But, Sam then read a significant amount of good news about the stock and the economy in general and bought the stock back for $20, less than 31 days after the sale.  Sam will not be able to deduct the loss of $25 per share.  But he can add $25 per share   to the basis of his replacement shares.  Those shares have a basis of $65 per share: the $40 Sam paid, plus the $25 wash sale adjustment.  In other words, Sam is treated as if   he bought the shares for $65.  If Sam ends up selling the shares for $70, he’ll only    report $5 per share of gain.  If he sells them for $40 (the same price he paid to buy them), he’ll report a loss of $25 per share.

Because of the basis adjustment rule, a wash-sale is usually not a major disaster taxwise.  In many instances, the result is a simple postponement of the tax benefit of having sold stock at a loss.  Indeed, if the taxpayer receives the tax benefit later in the same tax year, there may not actually be any impact on taxes.  But, there are times when the wash sale rule can have a significantly negative tax impact.  For example, If the taxpayer doesn’t sell the replacement stock in the same year, the loss will be postponed, possibly to a year when the deduction is of far less value.  Also, if the taxpayer dies before selling the replacement stock, neither the taxpayer nor the taxpayer’s heirs will benefit from the basis adjustment rule.  Similarly, the benefit of the deduction can be permanently lost if the taxpayer sells the stock and arranges to have a related person buy replacement stock.  Furthermore, a wash sale involving shares of stock acquired through an incentive stock option can be a planning disaster.

Sales to Related Parties

As noted, a related party rule can come into play even though the wash-sale rule does not explicitly contain a related-party rule.  The rule bars loss deductibility when a “taxpayer” sells stock at a loss, and then the “taxpayer” buys substantially identical securities within 30 days before or after the sale as replacement shares.  But, the way the IRS interprets “taxpayer” is in terms of control.  For example, the IRS has ruled that a taxpayer triggers the wash sale rule when stock is sold at a loss and the taxpayer’s IRA buy’s substantially identical stock within 30 days before or after the sale.  Rev. Rul. 2008-5, 2008-3 I.R.B. 272.  The rationale was that the taxpayer had retained control over the stock.  The IRS later extended its position to stock a taxpayer sells which is then bought by the taxpayer’s spouse or controlled corporation.  See, e.g., IRS Pub. 550.  In essence the IRS position will capture any transaction that involves any type of entity that a taxpayer uses to maintain indirect ownership of other assets, including stock.   

The end result of the IRS position is that even if repurchases by a related taxpayer don't fall within the wash sale rule, a loss can be disallowed under the related taxpayer rules of I.R.C. §267.  In addition, the U.S. Supreme Court has held that a transaction between related taxpayers consisting of two separate parts might be treated as a single sale to a related taxpayer, resulting in a disallowed loss.  McWilliams v. Comr., 331 U.S. 694 (1947).  However, transactions between related parties through an exchange that is purely coincidental and is not prearranged are not caught by the related party rule.    

Planning for Wash-Sales

What, if anything, can be done to plan around the wash-sale rule? Clearly, a taxpayer can sell the stock and wait 31 days before buying it again.  But, the risk with this strategy is that the stock may rise in price before it is repurchased.  If the taxpayer is convinced that the stock is at rock bottom, the strategy might be to buy the replacement stock 31 days before the sale. If the stock happens to go up during that period the gain is doubled, and if it stock value stays even, the taxpayer can sell the older stock and claim the loss deduction.  But, the strategy could backfire – if the projection about the stock turns out to be wrong, a further decline in value could be painful.  If the stock has a strong tendency to move in tandem with some other stock, it might be possible to reduce the risk of missing a big gain by buying stock in a different company as "replacement" stock. This is not a wash-sale because the stocks are not substantially identical. Thirty-one days later the taxpayer could switch back to the original stock if desired.  But, there's no guarantee that any two stocks will move in the same direction, or with the same magnitude.

So, the bottom line is that there is no risk-free way to get around the wash-sale rule. But it’s just as true that continuing to hold a stock that has lost value isn't risk-free, either. It’s really up to each particular investor to evaluate all the risks, and balance them against the benefit that can be obtained by claiming a loss deduction.

Conclusion

The wash-sale rules are important to understand in terms of what losses they disallow.  They are designed to prevent a taxpayer from manipulating the tax code for the taxpayer’s advantage with respect to stocks or securities.  Sometimes, the rules come into play with respect to IRAs and entities, with little opportunity in taxpayers to avoid their impact.