- Waneta Jaikarran
How Wash Sales Affect Stock Trades
When trading stocks, you should be aware of wash sales. You probably won't realize gains on all of your trades. You may turn a profit on some trades while losing money on others. While you'll only have to pay taxes on gains, wash sales can affect your tax liabilities. What are wash sales exactly, and how do you avoid them?
The Basics of Wash Sales
A wash sale occurs when you sell a stock at a financial loss, followed by repurchasing either the same stock or an equivalent stock within a 30-day period. It's the underlying concept of the wash sale rule. The wash sale rule is designed to discourage traders from selling stocks for the sole purpose of lowering their tax liabilities.
The wash sale rule has been around for nearly a century. Before the wash sale rule was enacted, traders would often sell stocks at a loss to offset their capital gains. To curb this practice, the U.S. government created the wash sale rule.
Selling a stock at a loss will typically offset your capital gains for the year in which you sold it. For example, if you've realized $50,000 in gains from other stock sales during that same year and then sell a stock at a $10,000 loss, you'll have $40,000 of capital gains - assuming you didn't sell any other stocks at a loss. You'll have to pay taxes on these capital gains.
When a wash sale occurs, you won't realize a loss. Rather, the loss will be carried over the cost basis of the new stock purchase. If you sell a stock at a $10,000 loss and then repurchase it within 30 days, your capital gains won't be offset by $10,000 because you won't realize the loss. The $10,000 loss will be added to the cost basis of the new stock purchase.
It's important to note that wash sales only apply to losses and not gains. You can repurchase the same stock after selling it for a profit without triggering a wash sale. Only loss-incurring trades will trigger a wash sale.
The Impact of Wash Sales
Wash sales aren't illegal, nor do brokerages prohibit them. And contrary to what countless traders believe, they don't eliminate the tax deductions associated with losses. Whether you trigger a single wash sale or dozens of wash sales, you'll still be able to deduct those losses from your capital gains, thus lowering your tax liabilities.
Losses from wash sales are simply deferred. All wash sales involve selling a stock at a loss. When you repurchase the same stock that you sold for a loss within 30 days, you'll trigger a wash sale. The losses will then be added to your new cost basis. You won't realize losses from a wash sale until you sell the stock a second time.
Your tax liabilities may be higher for a given year if you experience wash sales. All wash sales triggered in December will defer the losses from those trades until at least the following year. When you file taxes for the year in which those wash sales were triggered, you may have to pay more to Uncle Sam than expected.
Ultimately, the Internal Revenue Service (IRS) only requires you to pay taxes on gains. Wash sales involve losses. You can leverage those losses to offset the gains realized from your profitable trades. Triggering wash sales will only defer those losses.
You'll have to track wash sales for tax purposes. Most brokers will automatically update the cost basis of your trades when wash sales are triggered. Nonetheless, you shouldn't trust your broker to perform this task.
Brokerages can make mistakes. When your broker sends you a Form 1099, it may not include wash sales for that year, or the Form 1099 may contain inaccurate information about the wash sales. By tracking wash sales yourself, you won't have to worry about errors made by your broker. You can track wash sales in a spreadsheet. If you only have a few wash sales, alternatively, you can track them in a text document.
How to Avoid Wash Sales
There's nothing wrong with cutting your losses on a stock, but you should typically try to avoid wash sales. The easiest way to avoid wash sales is to wait at least 31 days before repurchasing the same stocks that you previously sold for a loss. Wash sales are limited to a 30-day window. By waiting at least 31 days, you can repurchase the same stocks without triggering a wash sale.
Diversifying your portfolio can minimize your risk of triggering wash sales. Instead of repurchasing the same stock that you previously sold for a loss, for instance, consider purchasing a different stock in the same industry. Wash sales are only triggered by repurchasing the same stock or an equivalent stock. By purchasing a different company's stock, even if the company operates in the same industry, you can avoid triggering a wash sale.
If you actively trade stocks, you may want to talk to a professional accountant about wash sales and how to avoid them. Most professional accountants are familiar with the wash sale rule. They can review your portfolio and trading habits while offering advice on how to avoid wash sales.
Keep in mind that wash sales aren't limited to shares. The wash sale rule applies to options as well. Calls are bullish options to purchase 100 shares of a stock. If you buy 100 shares of a stock, sell those shares at a loss and then purchase a call within the next 30 days, you'll trigger a wash sale. Some put option trades can also trigger wash sales.
Wash sales are bound to happen. Nearly all retail traders, as well as institutional traders, will experience them. They occur when selling a stock at a loss and then repurchasing the same stock or an equivalent stock within a 30-day period. To avoid wash sales, you can either wait 31 days before repurchasing the stocks, or you can purchase different stocks.