The IRS Wash Sale Rule

Selling your losing stocks to save on capital gains taxes is a good strategy if you avoid the IRS wash sale rule. Learn about the wash sale rule here.

If you have substantial gains from sale of stock and no losses to offset the gains, you may be in for a hefty tax bill. Those of you who trade stocks often may have the idea to sell some of your loser stocks in order to realize a loss. This is a good strategy if you avoid the IRS wash rule.

The IRS does not allow you to sell a stock simply to take a tax loss. For that reason, you are not allowed to take a tax loss on a stock if you sell and repurchase within 30 days (before or after the sale). According to the IRS, a wash sale results when "you sell or trade stock or securities as a loss and within 30 days before or after the sale you: 1) Buy substantially identical stock or securities, 2) Acquire substantially identical stock or securities in a fully taxable trade, or 3) Acquire a contract or option to buy substantially identical stock or securities" (IRS Publication 550: Investment Income and Expenses). If you buy the same stock or security 31 days before or after your loss transaction, then the wash rule is not in effect and you can deduct the loss. Wash sales are not illegal, but they do not result in an immediate tax benefit. When you complete a wash sale, your basis in the stock or security you bought in the second purchase is your original basis from the first purchase (plus any transaction fees). In other words, your loss is deferred until you sell the stock or security in a non-wash sale.

Before selling a stock for a loss, it is wise to have a plan. Among others, there are three strategies you could take when selling for a loss:

1. Plan to repurchase the same stock in 31 days. By doing this, you have realized your loss and saved on your tax bill. Furthermore, after a month you will still own the stock. The risk here is that the stock will rally during that month and it will cost you much more to re-buy the stock.

2. To shield from a potential rally, you could buy a similar stock during the waiting period. Many times, stocks in the same sector will rally simultaneously. So, if you are selling a stock for a loss, look for an attractive competing stock and "park" your money there. When the waiting period is over, sell the competitor stock and re-buy your original stock. This way, if the sector rallies are less likely to miss out on gains from the rally.

3. Evaluate whether the stock is still attractive. Why is the stock a loser? If it is because something has changed with the company since you purchased the stock, you may not want to re-buy at all. Evaluate other investments. If there are more attractive stocks that you do not own, then taking the loss and reinvesting in the more attractive stocks may be the best option. When evaluating this option, keep in mind your original investment objectives and consider your level of diversification. While stocks in some sectors may not seem as attractive as those in the hot sectors, it is wise to hold both out-of-favor and hot stocks in order to lower your risk.

There are of course special circumstances and exceptions that affect application of the wash sale rule. To learn how the wash sale rule applies to your unique situation, consult your tax advisor or the IRS.

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