What Is a Wash Sale? 

Investing in the stock market is a way to build wealth and create passive income. However, investing comes with risk, which can look like the value of investments plummeting when the market isn’t doing so well. Sometimes, investors can benefit from market losses through a tax break called the capital loss tax deduction. Some investors lose out on this tax break when they do what’s called a wash sale.

What Is a Wash Sale?

When you sell a security that has declined to take advantage of the tax benefit and then buy a security of the same or similar value, that’s known as a wash sale. The said tax benefit is the capital loss tax deduction, when you deduct securities that have lost value from your tax return. The IRS allows individuals to deduct up to $3,000 in net capital losses annually. Any additional losses can be carried forward into future years.

Some investors engage in wash sales intentionally while for others, it’s an oversight. Either way, wash sales could lose some of the capital loss tax benefits. It’s important to note that wash sales aren’t illegal-they prevent individuals from taking a tax deduction on said securities with net losses.

Rules Around Wash Sales

The rules around wash sales are pretty straightforward–when a security is sold at a loss, the same security or a similar one shouldn’t be purchased 30 calendar days before or after the sale. That means the window for wash sales is 60 days.

Wash sale rules apply to multiple types of securities, which include stocks, contracts, bonds, mutual funds, and ETFs. If this rule isn’t followed, investors can’t take a loss for that security in their current tax return.

For example, let’s say an investor purchased 200 shares of a stock trading at $15 per share worth $3,000. A year later, the stock price dropped, trading at $10 per share, leading to a $1,000 loss. The investor may decide to sell all 200 shares after realizing that $1,000 loss. Assume the stock price drops even further to $5 per share. The investor may still see potential in the company and decide to repurchase the stock and take advantage of the lower price, which could result in significant gains if the stock price goes up significantly in the future. If the investor buys these stocks 30 days before or after selling them, this would be considered a wash sale. That investor cannot deduct the losses on his or her taxes.

The IRS established the Wash Sale Rule to prevent investors from taking advantage of the capital loss tax break during tax time. Some investors were selling securities and then repurchasing them at or below the price they sold them for within a short timeframe to get the capital loss deduction and minimize their tax bills. It wouldn’t be illegal for these investors to proceed with these transactions, but they wouldn’t be allowed to take a tax deduction on that year’s tax return.

To avoid a wash sale, investors should wait 31 days or more to purchase a security after selling the same security that declined in value. Investors may also consider buying securities that are somewhat similar but not identical to the securities they sell. Unfortunately, there isn’t a textbook definition of what the IRS considers ‘identical,’ so investors must use their own judgment.