Tax loss harvesting is a valuable tool employed by savvy investors to reduce their tax obligations. Unfortunately, a wash sale is one of the most technical aspects of tax loss harvesting, and is often misunderstood. In order to maximize the benefit of a wash sale, investors need to understand how and when it applies.
What Is a Wash Sale?
A wash sale occurs when an investor sells a security at a loss (i.e. the sale price is less than the purchase price) and then repurchases the same security or “substantially identical” security within 30 days before or after the sale date. The IRS recognizes this as a wash sale and any deductible loss is disallowed, meaning the loss cannot be used to reduce their tax liability.
When Does a Wash Sale Apply?
A wash sale is most likely to occur when an investor is trying to take a tax loss on a security that they expect to rise in value. Generally, the investor will sell the security (at a loss) and use the proceeds to buy a similar security, thus maintaining their exposure to the asset.
It is worth noting that the IRS may consider similar securities to be substantially identical, even if there are some minor differences. For example, shares of the same stock traded on different exchanges (e.g. NYSE and NASDAQ) may trigger a wash sale.
What Should Investors Know About Wash Sales?
The IRS may assess a penalty for wash sales based on the amount of taxable loss disallowed. Ultimately, investors should be mindful of the timing of any sell transactions to avoid potential wash sales. Additionally, it is possible to apply a separate strategy, such as a tax hedging strategy, to offset any potential wash sale implications.
When used appropriately, tax loss harvesting can be a powerful tool to lower a taxpayer’s liability. However, it is important to understand wash sales and the implications for tax loss harvesting.