Introduction

Wash sales are a potential tax trap for investors hoping to deduct capital losses. In declining markets like 2022's, it can be beneficial to make sure you don't run afoul of the laws while taking advantage of tax-loss harvesting to decrease your taxes. One such rule is the prohibition against engaging in a wash sale.

How the Wash-Sale Rule Works?

The wash-sale rule was established so taxpayers wouldn't take advantage of the situation by selling stocks but still holding on to them. By the wash-sale rule, you have 61 days to make your purchase. That is, the day of the transaction plus 30 days and the day after the transaction plus 30 days. The wash-sale rule will no longer apply to subsequent sales of the same security or substantially identical ones after the time above the limit has passed.

Despite the wash-sale rule potentially disallowing a loss, the amount of the loss will be added to the price of the purchase that triggered the rule. The resulting loss can be written off when the stock is eventually sold. Accordingly, we can say that the initial loss has been postponed. The wash-sale rule also applies to the loss-making sale of options (valued in the same ways as stocks) and the subsequent purchase of the same options within 30 days.

Illustration of a Bogus Purchase

Here we'll assume you have fifty shares of XYZ stock in a taxable brokerage account. If you purchased 500 shares of stock at $10 each, your cost basis is $500. On July 31, the stock is only worth $5 per share, and you sell all 50 shares for $250. Since you invested $500 but only realised $250 from the sale, you sustained a loss on the trade of $250. For the argument, let's imagine that on August 15, you decide to invest in XYZ by buying some more shares. The wash sale rule is triggered because the transaction occurred within 30 days of July 31. There are two possible outcomes because of this. First, we'll take off a loss on the transaction until August 1. Second, an amendment is made to the cost basis of your new XYZ holdings.

Why Do Wash Sale Rules Exist?

The wash sale restrictions aim to discourage investors from liquidating their holdings and reinvesting the proceeds in the same security. All investors do it for the same reason:

You are causing a loss that can be deducted from your taxes—taking advantage of the loss to reduce the tax liability associated with selling other stocks. They are still holding onto the stock/security in their portfolio. It is illegal to sell a stock or mutual fund at a loss and repurchase it within 30 days to recoup the losses. The basis of the shares sold in a wash sale must be calculated. If you find yourself in this situation, know that the disallowed loss amount must be added to the basis of the shares that resulted in the wash sale. It will help if you consider these your new shares. The loss is postponed but not eliminated permanently in this manner. When you sell the new stock, you'll pocket the loss.

How To Calculate A Wash Sale Adjustment?

When an investment is sold in a wash sale, the loss is postponed until the sale is completed and the gain or loss is realised. The loss is added to the cost basis to determine the new cost basis for the security.

How To Avoid Violating The Wash-Sale Rule?

Capital losses can be deducted from your taxable income, and gains can be reduced by using the loss as a counterbalance. A net loss of up to $3,000 may be deducted in any year if it meets the criteria for an allowable loss. In other words, the gains can be more than cancelled out by the tax benefits available to you under the law. To reduce their taxable income, astute investors often harvest losses. However, if you have a wash sale, you will not be able to take the deduction until 30 days have passed since the asset was sold and it has not been repurchased. After that period, the asset can be purchased again without violating the wash-sale regulations. If you incur a loss due to the repurchase and subsequent sale, you will be required to wait 30 days before making another asset purchase to avoid a "wash sale."

Conclusion

Investors must prevent a wash sale by waiting until the 31st day to repurchase security after selling it with the intent to repurchase it. If the investor doesn't do this, they won't be able to claim the capital loss on their tax return.