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Q.: In your article, Can I use tax-loss harvesting to offset my required IRA withdrawal? you wrote that when a wash sale occurs, the loss is disallowed but doesn’t necessarily go to waste. Could you explain that?
— Edgar
A.: I am happy to try, Edgar. People often want to harvest a loss for tax purposes but wish to keep a holding for the long term. Capital gains are taxed at lower rates than ordinary income and the tax law allows some losses to lower a taxpayer’s bill to encourage investment and risk-taking in the capital markets. The apparent thinking behind wash sale rules is that without them, you could sell a holding and immediately buy it back triggering a loss without changing the risk inherent in holding an investment.
The wash sale rule states that if you (or your spouse for joint filers) sell a security at a loss and buy the same or “substantially identical” security within 30 calendar days before or after the sale, the loss is not usable on that year’s tax return even if the trades occur in different accounts.
There are three ways to harvest a loss and not run afoul of the wash sale rule.
1. Sell a holding for a loss and buy it back at least 31 days later. This technique means you risk buying the holding back at a higher price.
2. Buy more of the security, wait 31 days, then sell shares showing a loss. This technique means you risk the price of the holding declining further an incurring a greater loss.
3. Sell the holding and immediately buy a similar but not “substantially identical” replacement. This is commonly referred to as a swap.
Unfortunately, the IRS does not say much about what “substantially identical” means. The primary explanation is found on pages 56 and 57 of Publication 550 but it says almost nothing that relates to mutual funds. Taxpayers are left to make their own decisions and defend them when questioned. From what I have seen, swapping an S&P 500 index SPX, -0.14% fund for another S&P 500 index fund from another company would be an aggressive choice.
Avoiding the wash sale rule can get tricky when you are adding or withdrawing funds regularly or there is a lot of trading in accounts. Because reinvested dividends buy more shares, they are notorious for triggering wash sales.
When a wash sale is disallowed, it does not disappear entirely. It is added to the cost basis of the newly purchased security.
For example, you buy 1,000 shares of ABC at $10 per share. The price drops to $8 at which point you sell to harvest a $2 per share loss. You still want to be in ABC so two weeks later when the stock is at $7 you buy 1,000 shares of ABC. Because the second purchase occurred within 31 days of the sale, the $2 per share loss is disallowed due to the wash sale rule.
You now own 1,000 shares of a $7 holding worth $7,000. Your basis is $9,000 comprised of the sum of the $7 per share purchase amount and the $2 per share disallowed loss times 1,000 shares. The date the first 1,000 shares was purchased is the date used to determine whether a sale is treated as a long term gain or loss.
If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line.
Dan Moisand is a financial planner with Moisand Fitzgerald Tamayo in Orlando and Melbourne, Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.
