A wash sale is a transaction where an investor sells an asset at a loss and then repurchases the same or a “substantially identical” asset within 30 days. The wash sale rule prevents investors from taking advantage of the tax code to minimize their capital gains taxes.
The wash sale rule applies to stocks, bonds, and other securities, as well as contracts or options to buy or sell these investments. The rule also applies to mutual fund shares and partnership interests.
How Wash Sales Work
Wash sales usually occur when an investor sells a security at a loss and then buys back the same security, or a “substantially identical” security, within 30 days. The 30-day period includes the day of the sale, the day before the purchase, and the 28 days in between. If an investor violates the wash sale rule, the IRS will disallow the deduction for the loss.
For example, let’s say that you sold 100 shares of ABC stock on December 1 for a $1,000 loss. On December 3, you re-bought 100 shares of ABC stock. The IRS would consider this a wash sale because you sold ABC stock at a loss and then bought ABC stock within 30 days. As a result, you would not be able to deduct the $1,000 loss on your taxes.
Violating the wash sale rule is not tax fraud. However, if you intentionally violate the rule to avoid paying taxes, you could be subject to penalties and interest charges.
The Wash Sale Rule and Day Trading
Day traders are especially susceptible to violating the wash sale rule because they frequently buy and sell securities within short periods of time.
For example, let’s say that you buy 100 shares of XYZ stock on Monday for $10 per share. On Tuesday, XYZ stock drops 10% so you sell it for a $100 loss. Then on Wednesday, XYZ stock rebounds 5%. You buy it back because you think it will continue to rise. However, XYZ stock drops again on Thursday so you sell it at another loss.
In this case, you would have two wash sales because you sold XYZ stock at a loss within 30 days of buying it back—once on Tuesday and again on Thursday. As a result, you would not be able to deduct either of the losses on your taxes until you have closed trading the ticker for at least 30 days. If this happens close to year-end 12/31; the losses defer into the next tax year. This is a “wash sale deferral”; which creates income that you didn’t actually recognize for the year.
Naked Shorting and Wash Sales
Another way that investors can violate the wash sale is through what’s known as “naked shorting.” Naked shorting occurs when an investor sells shares of a security that they don’t own—and don’t intend to buy—in hopes that the price will drop so they can buy it back at a lower price later.
For example, let’s say that you expect ABC company’s stock price to drop so you “sell” 1,000 shares short even though you don’t actually own any shares of ABC stock (this is legal as long as you eventually borrow or buy those shares). On Monday morning, ABC company announces poor earnings results so its stock price plummets 15%. You immediately buy 1,000 shares of ABC company’s stock to cover your short position before its price falls any lower (this is called buying to cover).
In this case, you have not triggered the wash sale rules because more than 30 days have passed since you sold ABC company’s stock short (even though you didn’t actually own any shares). However, if you had sold ABC company’s stock short on Friday afternoon and then bought to cover on Monday morning—within three days—then you would have violated the wash sale rules because less than 30 days had passed between transactions.
It’s important to be aware of the wash sale rules if you’re an active trader or investor because violating them can limit your ability to deduct losses on your taxes. However, as long as you’re careful about timing your trades and understand what constitutes a “substantially identical” security, then you should be able to avoid violating the rules altogether. Using a software solution such as TraderFyles can help properly calculate wash sales.