amid market volatility - beware of wash sales
Volatility is the price investors must pay in the search for higher future returns in capital markets. The reminder that volatility and risk - is indeed quite real - has been brought to the forefront the last several months. First with prices rapidly declining, and then rebounding in the global equity markets. To many savvy investors with taxable investment accounts, the declines we saw in February and March (and quite possibly going forward still for some time) may have actually presented opportunities. One such opportunity has been to capture valuable tax losses from their investments. However, these same investors need to be especially careful to navigate the wash sale rules of the Internal Revenue Code (IRC) Section 1091, or their tax loss strategy may have all been for nothing.
Refresher on capital losses
Before explaining what exactly a wash sale is, and why it is especially relevant now, we need to understand why someone would be enticed to sell at a loss in the first place. Taxpayers that sell an investment for a loss in a taxable brokerage account may typically be able to take that loss as a tax deduction, subject to certain limitations. The limitations are generally that losses can be used to offset any other realized gains (investments sold at a gain) plus up to an additional $3,000 of losses they may have taken, which can be used to offset other regular income on their tax returns. Losses above and beyond $3,000 (for married filing jointly, or single taxpayers) more than any realized gains can be carried forward to future tax years if unused in the current year. As such, many investors that experienced a steep decline in their taxable investment portfolio at some point this year, may have decided to sell an investment at a loss to capture the associated tax benefit if they were paying attention.
wash sales
After selling though, what if an investor wants to reinvest to remain invested in the market? Generally, this is exactly what an investor should be doing if their financial plan dictates doing so. Reinvesting proceeds back into the broader market helps avoid missing any potential recovery. What many investors are not as familiar with however, is that if they purchased the same or substantially identical security as the originally held investment within 30 days before or 30 days after the sale date, that the loss from their sale would be disallowed due to the wash sale rule of IRC Section 1091.
The IRS defines a wash sale as "a sale of stock or securities at a loss within 30 days before or after you buy or acquire in a fully taxable trade, or acquire a contract or option to buy, substantially identical stock or securities." The wash sale rule under IRC Section 1091 exists to prevent investors from generating, and recognizing, “artificial losses” in situations where they do not intend to reduce their holdings in the securities that are sold - even if they determine this after the fact from when they first sold. The loss on the sale is deferred until the replacement shares of the substantially identical security is sold.
Going a step further, investors need to be aware of these rules within their retirement accounts and when engaging in any options or similar derivative contracts for a given security. There are also nuanced attribution and consolidation rules that need to be monitored between spouses and related entities and businesses.
An Example
You purchase 1,000 shares of ABC Inc. for $10 per share. You eventually sell these shares for $7 per share, creating a $3 per share loss - or $3,000 total capital loss from the transaction. After you sell though, the price quickly rises back up to $9 per share, within 30 days of your initial sale. Considering you had originally purchased this stock for $10 per share and see the recent rise of the stock, you fear you may miss out and so you quickly repurchase 1,000 shares for $9 per share. Doing so however prevents you from taking the $3,000 loss you had already realized. Instead that $3,000 loss gets added to the cost basis of your new purchase. So rather than having a $3,000 loss and new shares with a total cost of $9,000 (1,000 * $9), you would have $0 loss and a total cost of $12,000.
Overall, wash sales can be a confusing and nuanced area of the tax code for individual investors and taxpayers when confronted with them in reality. When markets are volatile and prices are moving with more velocity than usual, there are increased opportunities for savvy tax-loss-harvesting strategies, but without proper execution and monitoring it can also lead to increased opportunities for unwanted wash sales. While losses deferred by wash sales will eventually be realized by a taxpayer in most instances, avoiding them in the first place is often preferred to more likely maximize investment performance. We encourage investors and taxpayers to consult or work with a financial or tax professional that is well-versed and capable of navigating the wash sales rules when managing an investment portfolio.
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