One of the best ways to prepare your year-end finances for optimal tax efficiency is to sell some of your investments at a loss in order to offset capital gains, or to offset some of your income. Your investment losses can offset your capital gains, plus offset up to $3,000 in income. (Any extra losses can be carried forward indefinitely.) As a result, if you don’t mind locking in a loss, you can sell a losing investment and use it to offset your income.
However, the IRS doesn’t want you taking advantage of the ability to use investment losses to your advantage. In order to ensure that you aren’t basically purchasing stock to replace identical stock you sold, the IRS has instituted what is known as the wash sale rule. The IRS wash sale rule applies to not only stocks, but also to bonds, options, mutual funds and so forth.
The IRS Wash Sale Rule
Basically, the IRS won’t let you offset your capital gains and your income with investment losses in certain situations. What is a wash sale? It is the sale or trade of a security at a loss and in 30 days before or after the sale you:
- You buy or acquire substantially identical stock/securities
- Acquire a contract or option to buy substantially identical stock/securities
- Acquire substantially identical stock for your IRA or Roth IRA
Without this rule, investors would sell losers at a loss, take the tax deduction, and then turn around and re-purchase the investment at a bargain price. The investor could then see a big profit later, if the stock price rises.
So, in order to prevent this sort of behavior, the IRS introduced the wash sale rule. If you buy a “substantially identical” security within 30 days of selling the investment, it’s considered a wash – and you can’t use your losses from the sale to offset your income and lower your tax bill. If you do repurchase an investment within the time period and claim your deduction, the IRS might assess you penalties on top of requiring you to pay what you owe in taxes.
Understanding “Substantially Identical”
Unfortunately, there is no straight cut and dry explanation of what the IRS means by “substantially identical.” Obviously, you can’t buy the exact same thing back. However, the IRS doesn’t seem to mind if you buy something in the same sector. So, you could sell your Dell stock and be just fine purchasing Apple or HP stock, or sell your AT&T stock and purchase Verizon stock.
Something becomes “substantially identical” when the price of one stock is directly tied to the price of another. If you sold your T-Mobile stock, and the company announced that it would merge with AT&T, you couldn’t buy AT&T stock within 30 days if you wanted to use the losses to offset your income. This is because the two stocks are linked in terms of performance – and may even become the same company! Some tax professionals also recommend caution when it comes to mutual funds, especially funds pegged to a specific index. It might not be best to sell a loser pegged to the S&P 500, and then turn around and buy another product, pegged to the same index, from a different broker. There are no hard and fast rules, but the right tax professional can help you work out what might qualify as “substantially identical,” and what isn’t.
The important thing, of course, is to be careful. It’s convenient that you can offset some of your income with investment losses, but you need to make sure what you’re doing is above board as far as the IRS is concerned. Make sure if you want to get the tax benefits, sell securities at a loss more than 30 days before or after the purchase of substantially identical securities.