The Wash Sale Rule: How to Accidentally Destroy Your Tax Deduction
The Wash Sale Rule: How to Accidentally Destroy Your Tax Deduction
COACHING POINTS
- The Rule: The IRS disallows a tax deduction for a capital loss if you buy a “substantially identical” stock or security within 30 days before or 30 days after the sale. This is called a Wash Sale.
- The Penalty: You don’t lose the money, but you lose the immediate tax benefit. The disallowed loss is added to the cost basis of the new shares, effectively deferring the tax break until you sell the new shares years later.
- The Workaround: To harvest a loss without leaving the market, you must swap into a similar but not “identical” asset (e.g., selling Coke to buy Pepsi, or selling an S&P 500 ETF to buy a Total Market ETF).
Tax-Loss Harvesting (#55) is a powerful tool, but it has a trap door. If you sell a losing stock on December 30th to lower your taxes, and then get excited and buy it back on January 15th, the IRS will erase your deduction. The “Wash Sale Rule” exists to prevent investors from claiming artificial losses while maintaining their position. Understanding the 61-day window is critical for active traders. Source: IRS Publication 550 (Investment Income)
Scenario: You bought Tesla at $1,000. It drops to $600.
- Step 1 (The Sale): You sell 1 share at $600.
Realized Loss: $400. (You plan to deduct this). - Step 2 (The Mistake): 2 weeks later, you buy Tesla back at $620.
IRS Ruling: Wash Sale Triggered. The $400 loss is disallowed on this year’s tax return. - Step 3 (The Adjustment): The $400 loss is added to your new cost basis.
New Basis: $620 (Buy Price) + $400 (Disallowed Loss) = $1,020.
Result: You get the tax benefit only when you sell this new share in the future. Immediate tax savings = $0.
The 61-Day Danger Zone (Risk Score)
| Time Period | Wash Sale Risk (0-100) |
|---|---|
| 30 Days BEFORE Sale | 100 |
| Day of Sale | 100 |
| 30 Days AFTER Sale | 100 |
| Day 31+ | 0 |
*The window is not just “after” you sell. Buying extra shares just *before* you sell the old ones also triggers the rule (Risk Score 100 = Guaranteed Wash Sale).
What-If Scenario: The “ETF Swap” Loophole
Comparison: Buying back the same ETF vs. a Proxy ETF.
| Strategy | IRS Audit Risk (0-100) |
|---|---|
| Same CUSIP (VOO -> VOO) | 100 |
| Different Brand (VOO -> IVV) | 80 |
| Different Index (VOO -> VTI) | 0 |
Execution Protocol
This is the #1 cause of accidental wash sales. If you sell a stock for a loss, but an automatic dividend reinvestment buys 0.1 shares of that same stock within 30 days, the wash sale is triggered (partially). Turn off DRIP before harvesting losses.
The IRS treats married couples as one unit. You cannot sell Apple for a loss in your account while your spouse buys Apple in their account within the 61-day window. This counts as a wash sale.
If you love a stock but want to harvest a loss, buy a new lot of shares 31 days before you plan to sell the old lot. This doubles your position temporarily, but allows you to sell the old shares (with the loss) safely without being out of the market.
COACHING DIRECTIVE
- Do This: Use “proxy assets” to stay invested. If you sell Google, buy a Tech ETF (XLK) for 31 days to capture the sector recovery, then switch back to Google later if you wish.
- Avoid This: Ignoring the Wash Sale rule in December. If you trigger a wash sale in January, it’s annoying. If you trigger it in December, you might lose the deduction for the entire tax year you just finished.
Frequently Asked Questions
Does this apply to Crypto?
Currently, no. The Wash Sale Rule applies to “securities.” As of 2024, crypto is treated as “property,” so you can technically sell Bitcoin for a loss and buy it back immediately (but legislation may close this loophole soon).
What is “Substantially Identical”?
The IRS does not define this precisely. Common stock and preferred stock of the same company are usually different. But two S&P 500 ETFs from different providers are considered risky by conservative CPAs.
Does it apply to IRAs?
Yes. If you sell for a loss in a taxable account and buy the same stock in your IRA within 30 days, it is a wash sale. Worse, because the IRA has no cost basis, the loss is permanently lost, not just deferred.