Losing securities and wash sales

Not every security ends up generates a lot of returns. So, investors try to find a way to at least get something out of a losing security. There is a transaction called “wash sale.” Investors try to make the most out of a losing security when the calendar year ends. In this case, they can get the capital loss on taxes in that year. Why do investors do this? They most likely want to repurchase that security as soon as the New Year starts. It would benefit the most if the price were lower than the price it was sold. Throughout history, wash sale is a method that investors use when they know they have a tax loss and do not want to limit their exposure to opportunities to own particular security. Aside from investors, the IRS also uses this to eliminate the incentive to freely sell and reclaim the similar security somewhere around the end of calendar years.

What is a wash sale?

So, what if a country has tax laws that allow tax deductions when securities have losses held inside a given tax year? Yes, a wash sale will work. But what if the country does not provide these kinds of incentives? Then, there is no need for wash sales. But if there are incentives, wash sales will result.

The three parts

Awash sale is comprised of three parts:

  1. Investors realize that their position is losing towards the latter of the tax year. So, they close that said position either at the end or before the year ends.
  2. The sale can let the investors take a loss that they can claim legally on their tax returns. This serves as a reduction of their yearly earnings for the said year. Hence, they pay lesser taxes.
  3. As the New Year begins, the investor will try to repurchase that security either at or lower than the price they sold it.

Know the rules

Internal Revenue Service thought of a way so that this incentive will not be abused. They instituted the wash sale rule in the US. This rule states that for an investor who purchases a security within 30 days prior to or after selling it, the losses incurred from that sale will not be considered in the reported income. Hence, no one can abuse the incentive and make a wash sale in a short period.

For instance, you have a capital gain worth $10,000 when you sold Stock A. You are now under the highest tax bracket, so you must pay at least 20% of capital gains tax. This is $2,000 that will go to the government. However, if you sold Stock B for a loss of $5,000, your net capital gain for tax reasons will now be $10,000 – $5,000 = $5,000. It means that you should only pay $1,000 for capital gains tax. The realized loss on Stock B decreases the gain on Stock A. This also means that this lessens your tax bill. 

A recap

Wash sales happen when an investor sells a security at a loss for tax benefits. IRS felt like they need a wash sale rule so taxpayers will not abuse wash sales. In a nutshell, anyone who sells a security at a loss cannot buy shares of the security or something similar within at least 30 days before or after selling.