In a previous post, I reflected on some of the key differences between traders and investors. Investors are in it for the long-term, holding investments for years or decades. In contrast, traders take advantage of short-term market moves to buy and sell stock (or another financial vehicle), hopefully at a profit.

Another big difference: traders can trigger wash sales on a regular basis. Investors rarely do, but if you aren’t careful, you can run afoul of the IRS rules on wash sales.

If you sell a stock at a loss, then repurchase that stock (or something very similar) within thirty days, you’ve triggered a wash sale.

With a wash sale, you can’t count the loss on the first sale. Instead, you add that loss to the basis of the second thing that you bought. By readjusting the basis, you effectively get that “loss” back when you get around to selling the second thing.

1. Let’s say you bought a stock for $25, then sell it for $10. That’s a $15 loss.
2. Two weeks later you buy it back at $5. If this wasn’t a wash sale your basis in the second trade would be the amount you paid, or $5. Because we’re readjusting your basis, the second thing now has a basis of $20 ($5 + $15).
3. A month later, you sell your second trade for $25. You realize a gain of $5 ($25-$20 basis).
4. Had the second trade been on its own you would realize a gain of $20 ($25-$5 basis)
   • If done separately: $15 loss plus $20 gain nets $5 gain
   • As a wash sale: unreported loss plus $5 gain nets $5 gain; no difference

Back in the day, investors used to sell their losing investments in December, and use those losses to offset gains. Then buy everything back in January. The IRS did not take kindly to this particular loss-harvesting strategy and so the wash sale rule was born. (Loss-harvesting is still allowed, just without the “buy-back-in-January” part.)

“Substantially identical stock or security”

What exactly is a “substantially identical stock or security” that might trigger a wash sale? The IRS, in their usual vague way, states that it depends on the “facts and circumstances”.

• If you sell Microsoft (MSFT) at a loss and buy Apple (AAPL) that is NOT a wash sale. They are different companies.
• If you sell MSFT at a loss and buy Microsoft options (calls or puts) within 30 days, YES, that’s a wash sale
• If you sell MSFT at a loss and buy a mutual fund that contains MSFT (as a 4% member of the S&P500, most mutual funds include MSFT), that is also NOT a wash sale.

As an investor, you may also trigger the wash sale rules:

• Perhaps you sell an Index fund at a loss—the market is down—then realize your mistake and buy it back once the market starts to recover in a few weeks. YES, you’ve triggered a wash sale.
• Perhaps the first S&P500 index fund was from Fidelity, and the second S&P500 index fund was from Vanguard. Both are S&P500 index funds and meet the criteria of “substantially identical”. It’s a wash sale.

As you reinvest dividends and capital gains, you could also inadvertently trigger a wash sale. This is unlikely as you would need to sell at a loss first. If you are only selling to rebalance, this isn’t happening.

Another reason to simply stick to a “buy, hold, and rebalance” investing strategy.

Image by jacqueline macou from Pixabay 

You’ve triggered a wash sale, now what?

Traders can trigger wash sales constantly. As long as you conduct all your trading in a single account, your financial institution will keep track of these trades and report everything accurately on your end-of-year 1099 form.

The problem arises when you trade out of more than one account. The IRS treats ALL your accounts—plus all the accounts of your spouse—as one big account. If you sell something at a loss in account A but buy it back again in account B, you’ve triggered a wash sale.

But your financial institution doesn’t know about the wash sale, even if the two accounts are at the same place. You’re required to manually keep track and adjust how these trades are reported on your taxes.

But if your tax form doesn’t match your 1099, you will be flagged by the IRS. Before you file, in this situation, consulting with a good tax attorney may be in order.

(And evidently traders shouldn’t marry other traders?)

Even if you’re not a trader, you most likely have multiple investing accounts (and a spouse with multiple investing accounts). An employer 401K (or two), plus an IRA, maybe also a Roth IRA as well.

Another problem:

What if your first losing trade is in a regular taxable account, but you trigger the wash sale by purchasing the stock (or mutual fund) again in an IRA or another tax-advantaged account? Sorry, but your original loss is completely disallowed.

You can’t readjust the basis of a security within an IRA. You don’t get to offset that first loss with another gain somewhere else. It’s a permanent loss.

You’re not getting a penalty; you simply can’t write off the loss on your taxes.

Investing hygiene to avoid wash sales

If you’re a trader, avoid doing so in your tax-advantaged accounts. Save those accounts for your investments.

If you’re an investor, you need to be aware of what you are selling at a loss in a taxable brokerage account and avoid buying it back within the 30-day window in a separate account, especially a tax-advantaged one.

Spouses should practice open communication when it comes to finances. Admitting an investing loss to a spouse may be embarrassing, but in this case, it’s critical.

If you sell something at a loss within a tax-advantaged account, then buy it back, there are no tax repercussions because everything is (temporarily) protected from taxes, for both gains and losses.

As an investor, if you like to purchase individual stocks as an investment, either keep them exclusively in a single tax-advantaged account or exclusively in a single brokerage account. But not both.

You may have a lot of investing accounts lying around. More than you realize. Try to consolidate (rollover) as many as practical. You may have your 401K at work, plus a brokerage account there. Plus, a traditional IRA, plus a Roth IRA, plus a taxable brokerage account where your IRA lives. Any additional accounts and keeping track of them—and potential wash sales—is going to be a significant challenge.

Photo by Iz & Phil on Unsplash

Beware of company stock

401K at work? Most likely you have a separate taxable brokerage account at the financial institution where your 401K resides. If you receive stock grants of your company stock, that’s where they go.

When it comes to potential wash sales, those stock grants count.

Do you invest in company stock within your 401K? That counts also.

Indeed, per the IRS, if you sell company stock at a loss in a taxable account, then receive a new stock grant from your company within that 30-day window, that’s a wash sale.

Likewise, if you sell company stock at a loss within a taxable account, then soon after, buy more within your 401K, you’ve triggered a wash sale. This purchase may occur automatically as a result of your regularly scheduled deposits from your paycheck. That first loss is disallowed.

Most financial experts recommend against buying company stock within your 401K. It represents poor diversification. What if your company were to fall on hard times? Both your job, representing your regular income, plus the stock, are at risk.

Wash sales are yet another reason to not purchase the stock of the company you are currently working for.

(Don’t worry about unvested stock grants. As you can always lose them if you leave the company, there are no tax implications. Yet.)

Obviously, don’t say no to free stock, either within the 401K or outside of it. Just be careful about the timing of losses.

Wash sales, per se, are not bad, they are simply easier to manage when all relevant transactions occur in a single account.

The problems arise when something is sold at a loss in a taxable account, then repurchased again in a different account within 30 days.

At best, accounting becomes a challenge. At worst you’ll have a disallowed loss that you can’t write off on your taxes.

Good luck!

Additional Reading

• Are You a Trader or an Investor? Or Both? What’s the difference?

• The Trader Mindset. Lessons from trading that made me a better investor

• Following the Herd, and Five Other Big Investing Mistakes. Guilty of any of these? Stop Now

First photo credit: Ryan McGuire from Pixabay 

This information has been provided for educational purposes only and should not be considered financial advice. Any opinions expressed are my own and may not be appropriate in all cases. All efforts have been made to provide accurate information; however, mistakes happen, and laws change; information may not be accurate at the time you read this. Links are included for reference but should not be considered an implied endorsement of these organizations or their products. Please seek out a licensed professional for current advice specific to your situation.