A simple investing action that could increase your taxable income
Dear Tax Genius,
I use an online robo-advisor that manages my investments. The 1099-B and Form 8949 they sent me say I have a “nondeductible loss from a wash sale.” I’ve never seen anything about wash sales before. What is it and should I be concerned that my robo-advisor is making wash sales in my account?
- Hands-off Investor
Dear Hands-off Investor,
In the simplest case, a wash sale occurs when an investor sells a stock for a loss, and then buys back the same stock within 30 days of the sale. It's generally done in the hope of buying the stock for less money than they originally paid for the same number of shares. A wash sale on your tax return could mean that you’re missing out on some tax savings, so you may want to reach out to your robo-advisor for more details, particularly if your wash sales are causing you to miss out on hundreds or thousands of dollars of deductible income.
Normally, selling stock at a loss allows you to deduct that loss from your income, but the IRS doesn’t allow you to deduct the loss from a wash sale until a 30-day period has passed. Making a wash sale, particularly in the last month of the year, could mean you lost out on deductible income for the year. The IRS created the wash sale rule to prevent investors from gaming the tax system by selling stocks at a loss when prices go down and deducting that loss on their income taxes, only to quickly rebuy that same stock at a lower price and then cash in on higher net gains later on.
Investors generally want to avoid a wash sale in order to avoid deferring an otherwise deductible loss, but mistakes can happen, especially by high-volume traders like robo-advisors. Wash sales aren’t necessarily bad, but they can certainly complicate your taxes. It’s good to understand what a wash sale is since many more people are seeing them on tax forms with the rise of robo-advisors and investing apps.
If you’re an individual managing your own investments, there are some simple ways to avoid wash sales, which you can learn more about below.
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A wash sale occurs when an investor sells a stock or other security (like a bond) for a loss, and then buys either that same stock or a “substantially identical” stock within 30 days of the sale. Wash sales can apply when you trade common stock, preferred stock, stock options, bonds, securities futures contracts, or other types of securities. When determining whether a sale qualifies as a wash sale, there is actually a 61-day window because you must consider stocks you bought during the 30 days before the sale and the 30 days after a sale (plus the day of the sale itself).
As a very simple example of a wash sale, let’s say you spend $500 to buy 100 shares of stock of your favorite company at $5 per share. The stock price goes down to $2 per share, so you sell all 100 shares for $200, netting a loss of $300. Then the price goes up to $4 per share and you repurchase 100 shares for $400.
In this example, you spent $700 total to buy 100 shares that you used to own for $500, and that may be better than the alternative: spending $300 — your loss if you didn’t buy back the stock — to get no shares at all. But if instead of rebuying the shares you decided to take the $300 loss, you may be eligible for a tax deduction that could be even more valuable. We'll explain later exactly how wash sales affect your taxes.
To see if you have any wash sales, check the copies of Form 1099-B or Form 8949 that you received.
If you want the more technical wash sale rules, the IRS explains  that a wash sale can occur when you trade or sell a security at a loss and do one of four things within 30 days of that sale:
You buy substantially identical stock or securities.
You acquire substantially identical stock or securities in a fully taxable trade.
You acquire a contract or option to buy substantially identical stock or securities.
You acquire substantially identical stock for your IRA or Roth IRA.
If you aren’t selling and then buying the exact same security, then your sale probably doesn’t count as a wash sale. However, tax law does recognize some wash sales for buying a security that’s “substantially identical” to one you just sold.
The IRS doesn’t offer a specific set of rules for determining what is substantially identical (it instead offers the wonderfully vague guidance that you should “consider all the facts and circumstances in your particular case”) but stocks from different companies don’t usually qualify as substantially identical . One situation where you may buy a substantially identical security is if you sell stock from a company, the company reorganizes into multiple success companies, and you buy stock from one of those successor companies.
Trading different types of securities doesn’t usually qualify as a wash sale . So selling a stock from one corporation and then buying a bond from the same corporation generally doesn’t qualify as identical. The exceptions come when a security is convertible into the type you sold. For example, let’s say you sell shares of a company’s common stock and then purchase some of the company’s preferred stock. Those two types of stock may qualify as substantially identical if the preferred stock you bought has the possibility of one day converting into common stock.
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Wash sales are important because of their tax implications. When you make a wash sale, you cannot immediately deduct your losses from a sale and may have to pay more tax than you would if there was no wash sale.
A wash sale affects your taxes in three ways:
You cannot immediately deduct the loss from a wash sale.
Your holding period for the securities in your new purchase includes however long you owned the old security.
The loss from a wash sale is added to the basis of your purchase.
You cannot immediately deduct the loss from a wash sale, so it’s best to avoid wash sales if your goal is to deduct a loss and decrease your annual tax liability (how much tax you owe for the year). In more technical terms, the realized loss from a wash (the loss you experienced) is not deductible. Normally, when you sell stocks at a loss, the value of that loss is deducted from any capital gains you may have had, thus lowering your annual income and annual tax liability.
The holding period — how long you’ve owned a security — for the securities in your new purchase includes your holding period from the securities you sold. So if you own a stock for 100 days, you sell it, and then you buy it back within 30 days, the IRS considers your new stock as already having been owned by you for 100 days instead of starting over from zero days. This provision of wash sales can help you qualify for long-term capital gains rates more quickly .
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When you have a wash sale, the realized loss is added to the basis of your subsequent purchase. This part of the wash sale rule means that if you sold a security only to decide that you should have kept it, you could buy it back in a wash sale and minimize your total losses from selling too early. The easiest way to understand how this works is through an example:
Let’s say you own 100 shares of stock that you bought long ago for $4 per share. The basis (also called cost basis) of that stock is $400 and if you sell that stock in the future, your gain or loss is determined according to that $400 basis.
If the stock’s price falls to $1 per share and you sell all your shares, you have a realized loss of $300 ($400 basis - $100 sale value). That loss would normally be deducted from your income and decrease your tax liability for the year. But if the stock you sold then increases in price to $2 per share, and you decide to rebuy 100 shares within 30 days of selling them, then that is a wash sale. Your new stock, while worth $200 ($2 per share x 100 shares), will have a basis of $500 ($200 + your $300 loss).
Say a couple of years pass and you sell those 100 shares of stock when its price is $10 per share. For tax purposes, you will have a gain of $500 ($1,000 sale price - $500 basis). That $500 gain is less than you would have made if you had never sold the stock (your gains would’ve been $600 if you didn’t make the wash sale) but is still relatively good because instead of completely losing out on the future gains of that stock and taking a straight loss of $300, you make an $500 of income. And as long as you hold a stock for at least one year, you also pay the lower capital gains tax rates on that income.
For more help with your income tax return, try our guide to federal income taxes.
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Investors usually try to avoid wash sales so they can deduct losses in the current tax year, while also maintaining a certain asset allocation in their investment portfolio. Avoiding a wash sale also helps to simplify your taxes.
The most straightforward way to avoid a wash sale is to wait until after the 30-day wash sale period. Once that period is over, you can rebuy any stock you recently sold. If you don’t want to wait, another option is to buy a security that is similar to the one you just sold . Depending on your specific portfolio and investment goals, “similar” could mean a company in the same sector of the economy, with similar growth prospects, or with a number of other characteristics. Selling a security for a capital loss and then buying a similar security is basically tax-loss harvesting, a very common strategy that robo-advisors and financial advisors use to minimize a client’s tax bill.
You may also want to buy a different type of security than the one you sold. For example, after selling stock from a tech company, you may want to buy shares of an exchange-traded fund (ETF) or a mutual fund that invests in tech companies.
For more personalized investment or tax advice, it’s best to consult with a financial advisor.
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