You can dump an underperforming asset and get a tax break for it. But make sure to follow the rules that govern a Wash Sale.

What is a Wash Sale?

To make it simple, a Wash Sale is when you sell a security at a loss for the tax benefits, but then turn around and buy the same or a similar security.

How Does the Wash Sale Rule Work?

You can sell a security at a loss and buy the same or a “substantially identical” security within 30 calendar days before or after the sale, however, you won’t be able to take a loss for that security on your current year’s tax return. (IRS Pub 550)

Here are two incentives though: (1) You will be able to add the amount of the loss back onto the cost basis of the replacement security, which can help with taxes later and (2) in addition, the holding period of the original security gets tacked onto to the holding period of the replacement security.

Here’s an Example:

Let’s say you buy 1,000 shares of LMN stock for $10 per share ($10,000 of stock). One year later, the stock starts dropping, so you sell your 1,000 shares for $8 per share—a $2,000 loss. Three weeks later, LMN is trading at $6 per share and you decide that price is too good to pass up, so you repurchase the 1,000 shares for $6,000. This triggers a Wash Sale event.

As a result, the $2,000 loss is disallowed as a deduction on your current-year tax return and added to the cost basis of the repurchased stock. That bumps the cost basis of your $6,000 of replacement stock up to $8,000, so if you later sell that stock for $10,000, your taxable gains will be $2,000 instead of $4,000. And because you previously held LMN for a year, it will automatically be treated as a long-term capital gain, even if you sell it after just a few months.

So, it’s not all bad news. A higher cost basis decreases the size of any future gains realized from the sale of the replacement security, thereby lowering your future tax obligation.

If you sell the securities at a loss, the higher cost basis would increase the size of the loss for which you could claim a deduction on your taxes.

A potential advantage of the extended holding period is that it would lower your tax obligation if you sold the replacement security after less than a year. (Normally, short-term capital gains from investments held for less than a year are taxed at the higher regular income tax rate, while longer-term capital gains are taxed at the lower capital gains rate, as you might know).

What Types of Securities are Covered by the Wash Sale Rule?

Not all stocks, exchange-traded funds (ETFs), and mutual funds are eligible for wash sale rules but most of them are. You need to ensure that you are buying and selling a “substantially identical” type of security to qualify for a wash sale.

Q: What if I wanted to sell an underperforming security but didn’t want to be out of the market for an entire month just to avoid the wash-sale rule?

You could sell the loser at a loss and use the proceeds from that sale to purchase a similar—but not “substantially identical”—security that suits your asset allocation and long-term investment plan.

Unfortunately, the IRS hasn’t provided a straightforward definition of what it considers “substantially identical”.

Disclaimer: Investors will have to use their best judgment to avoid the wash-sale rules.

Q: Do underperforming securities in my Vanguard, or Schwab accounts qualify? What about my IRA?

The wash-sale rule applies across all your accounts, including those outside Vanguard, and Schwab, as well as transactions in your IRA—and the rule extends even to your spouse’s accounts. However, it’s for you to keep track of what’s happening across your various accounts. IRS regulations require Vanguard, Schwab, etc. to track and report wash sales within the same account.

  • Note that your loss under the wash sale rules would be disallowed if you reacquired a similar security within 30 days.

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