Tax law lets you use the losses from a sale of stock to offset your gains from other investments, which in turn reduces your taxes. So here's a clever idea: Why not sell stock at a loss, use the loss to cut your taxes, then buy the stock back immediately? It's so clever, in fact, that the Internal Revenue Service has a rule specifically intended to prevent people from doing it.
Sure, It's Legal
Understand one thing at the outset: It's perfectly legal to sell stocks at a loss and then buy them back immediately. You could do it over and over every day -- if you were so inclined and if your partner didn't wrestle the computer away from you -- until the accumulated losses and your broker's fees whittled your investment down to zero. But you're going to run into trouble if you try to use those losses to reduce your tax bill.
The IRS uses the term "wash sale" to refer to transactions in which you both sell a stock at a loss and purchase the same stock, or "substantially identical" stock, within the 30 days before or after the date of the sale -- a 61-day window. The IRS doesn't provide a concrete definition of "substantially identical" -- or even much of an abstract definition -- but if it's the same company's stock you may rest assured it meets the definition. It's also considered a wash sale if within the 61-day window you simply buy an option or contract on the stock rather than the shares themselves, or if you buy the shares and stick them in an IRA, or if you trade some other shares for the stock.
Ordinarily, when you sell shares for less than you paid for them, you incur a "capital loss." That's the opposite of a taxable capital gain, and you can use it to reduce your taxable income. But you can't declare a capital loss on a wash sale. The reason: For you to claim a capital loss, the IRS insists, you must actually lose money, and that's not what happens in a wash sale. Say you bought 10 shares of XYZ Corp. for $10 apiece, and now they have a market price of $8 a share. You sell them for $80 -- then immediately buy them back for $8 apiece. Before, you had $80 worth of stock. Now you have $80 worth of stock. No change. Yes, you're still down $2 per share -- but you're still holding on to the stock. To claim that capital loss, you have to "lock in" the loss by selling the stock and then keep your mitts off it for 30 days.
Why the Wash Rule?
You've probably figured out by now why the IRS wash rule exists: Without it, investors could sell stock that's currently down in price, use the temporary "loss" to eliminate taxes on other income, and then buy back the stock, getting right back where they started. Then, if the stock price went back up (as they hope), they would never actually experience the loss reported on their taxes.
You Do Get Something
The IRS doesn't completely shut you out of tax benefits on a wash sale. The temporary loss you incurred gets added to the cost basis of the repurchased stock -- the "starting price" that determines your taxable gain or deductible loss when you ultimately sell the stock for good. For example, if you paid $10 apiece for 10 shares of XYZ Corp., your cost basis was $100. If you executed a wash sale at $8 a share, the cost basis of the new shares would appear to be $80. But the temporary loss of $20 gets added back into that basis, so the cost basis remains $100. Down the road, if you sold those shares for $12 apiece, or $120 total, your taxable capital gain would be $20 ($120 minus $100) rather than $40 ($120 minus $80). And if you sold them for $90, you would have a deductible capital loss of $10 ($100 minus $90) rather than a taxable gain of $10 ($90 minus $80).