An important consideration when investing in a taxable brokerage account is the taxes you’ll eventually need to pay. The good news is there are some strategies available to help you reduce your capital gains taxes — or even eliminate them altogether.

Of course, even those tax reduction strategies come with their own rules and complications, including the IRS wash-sale rule. If you don’t tread carefully, this rule could prevent you from deducting certain investment losses, resulting in an increased tax liability.

Keep reading to learn more about how wash sales work, the wash-sale rule you need to follow, and how to use it in your capital gains tax planning.

Identifying a wash sale

A common tax-minimization strategy for taxable investing is to intentionally sell assets at a loss. You may do this for the purpose of tax-loss harvesting, which is the process of selling an investment at a loss for the purpose of offsetting a capital gain. Tax-loss harvesting can help reduce your tax bill by offsetting your capital gains with losses.

You may also sell a losing investment to reduce your overall tax bill. The IRS allows you to claim an excess loss of up to $3,000 per year, which could help to offset other tax liabilities.¹ And if your net losses exceed $3,000, you can carry them forward to reduce your tax burden in a future year.

But selling losing investments for the purpose of getting a tax benefit can easily enter a  gray area if done incorrectly. If you sell your securities at a loss and then turn around and buy substantially identical securities within a certain time frame, you’ve done a wash sale.

The legal definition of a wash sale is when you sell a security for a loss and, within 30 days before or after, do one of the following:

• Buy a substantially identical security
• Acquire a substantially identical security in a taxable trade
• Acquire a contract or option to buy a substantially identical security
• Acquire a substantially identical security in your individual retirement account (IRA)

What is the wash-sale rule?

The IRS wash-sale rule explicitly prohibits investors from deducting their losses from wash sales. The purpose of this rule is to prevent investors from abusing tax benefits.

For example, suppose you sold ABC stock for a gain of $1,000, which you know will result in capital gains taxes. You decide to sell your XYZ stock, which is currently down $1,000 from when you bought it. The loss on your XYZ stock offsets the gain on your ABC stock, so you won’t be on the hook for capital gains taxes.

What we’ve described above is perfectly fine. However, suppose you took the money from your sale of XYZ stock and immediately repurchased the exact same stock. You wouldn’t really have lost anything since you would have repurchased the stock at the same or similar price you just sold it for.

If you do a wash sale, the IRS requires that you add your disallowed loss to the cost of the new securities you’ve purchased to create your new basis, and you won’t be able to enjoy the loss deduction until you eventually sell the securities again.

In the long run, this cost-basis increase can actually be a positive thing. After all, with a higher cost basis, you can either reduce your capital gain or increase the capital gain if and when you sell the securities in the future.

If you complete a wash sale during the tax year, you’ll have to report it to the IRS. You’ll report your wash sale transaction using Form 8949.

It’s important to note that the wash-sale rule doesn’t just apply to individual stocks. It also applies to bonds, mutual funds, exchange-traded funds (ETFs), options and futures contracts, and more. However, as we’ll discuss in a later section, it doesn’t apply to cryptocurrency.

Understanding "substantially identical"

An important component of the IRS wash-sale rule is the term “substantially identical” to describe securities. Whether two securities are substantially identical is decided on a case-by-case basis. Not all common stocks from different corporations are necessarily substantially identical to one another, nor are common stocks and preferred stocks from the same corporation.

Repurchasing the same security you’ve previously sold clearly falls under the definition of substantially identical. Additionally, a preferred stock and a common stock of the same corporation may be considered substantially identical if some of the following are true:

• The preferred stock is convertible into common stock
• The preferred stock has the same voting rights as the common stock
• The preferred stock trades at prices that don’t vary significantly from the conversion ratio
• The preferred stock is unrestricted as to convertibility

Another situation in which two securities may be substantially identical is if a company has gone through a reorganization or a merger — then the securities of the successor company may be substantially equal to those of the predecessor company.

Why does the wash-sale rule matter?

The wash-sale rule can have an important impact on an investor’s ability to deduct their capital losses when filing their taxes. Under normal circumstances, you’re able to offset your capital gains with losses, therefore reducing your tax liability. But the wash-sale rule prevents you from doing that if you’ve purchased substantially identical securities within 30 days before or after the transaction.

And if you have a large tax bill, this scenario could be particularly painful. You could be subject to hundreds or thousands of dollars more in taxes, simply because you didn’t follow the wash-sale rule guidelines.

For example, suppose that several years ago, you purchased 500 shares of stock from a company for $50 per share — that’s a total value of $25,000.

Fast forward to today, the stock has grown considerably, and you’d like to use the profits to invest in renovations in your home. You sell the stock for $75 per share. That’s a total sale amount of $37,500 and a profit of $12,500.

Meanwhile, you have another stock in your portfolio that’s been severely underperforming. It happens to be down $12,500 since you purchased it — the same amount you’ve profited from the other stock. You sell the losing stock to offset the capital gains from your profitable stock.

As long as you don’t turn around and repurchase the exact same stock within 30 days before or after the sale, you’re able to deduct those investment losses. But if you do immediately repurchase the same stock, the wash-sale rule prevents you from deducting the losses. In other words, you’re stuck paying taxes on thousands of dollars of capital gains that you could have easily avoided.

If you’re using tax-loss harvesting to reduce your tax liability, it’s important to be aware of the wash-sale rule and take steps to avoid violating it. There are limited scenarios in which the securities of two different companies or the common stock and preferred stock of the same company are considered substantially identical. However, you’ll almost certainly be subject to the wash-sale rule if you sell and then repurchase the exact same common stock.

How to avoid a wash sale

As an investor, it’s important for you to take steps to avoid wash sales, whether intentionally or unintentionally. The good news is that with the right precautions in place, it’s relatively easy to avoid making a wash sale. Let’s talk about a few ways you can do that.

Mind the 30-day rule

First, the simplest way to avoid a wash sale is to be mindful of the 30-day rule. The wash-sale rule only applies when you purchase a substantially identical security 30 days before or after selling the original security for a loss. As long as you avoid that 61-day window, you won’t be violating the rule.

Buy a different asset

It’s entirely possible to use the benefits of tax-loss harvesting without entering into any gray area and without waiting the full 30 days after selling an asset to purchase another. You can avoid violating the wash-sale rule by simply purchasing a security that isn’t substantially identical to the one you recently sold.

For example, rather than repurchasing stock from the same company, purchase stock from a different company instead. According to the IRS, stocks from different companies generally aren’t substantially identical to one another.

Invest in diversified funds

Another way to avoid a wash sale is by investing in diversified funds like mutual funds and ETFs. Funds are an excellent way to gain exposure to many securities. And as an added benefit, they make it easy to avoid the wash-sale rule. You can simply sell one fund and repurchase a different one with similar exposure.

Consult a tax professional

If you’re unsure whether two securities are considered substantially identical, consult the help of a tax professional. If two securities are similar enough to make you question yourself, it’s best to get a professional’s advice to ensure you avoid violating this tax rule.

Is cryptocurrency subject to the wash-sale rule?

Cryptocurrency, which is a type of digital asset, has introduced some additional complexities to the tax laws. Despite its name, cryptocurrency isn’t a currency at all. Instead, it’s a type of digital asset that’s treated similarly to other investments for tax purposes.

Cryptocurrency is held to the same capital gains tax laws as other assets, including stocks and bonds. So, does that mean it’s also subject to the wash-sale rule?

The good news is the wash-sale rule doesn’t apply to cryptocurrency. The IRS considers cryptocurrency to be property but not a security. So, while it’s subject to capital gains and losses, it’s not subject to rules or laws that apply specifically to securities.

Of course, there’s an ongoing debate among lawmakers as to how cryptocurrency should be treated as it relates to securities and tax regulations. Therefore, whether the wash-sale rule applies to cryptocurrency could change in the future.

If you’ve made cryptocurrency transactions, it may be helpful to consult a tax professional when filing your income tax return, both to ensure you’re paying taxes on your cryptocurrency correctly and to find out if any of the tax regulations surrounding cryptocurrency have changed.

The bottom line

The wash-sale rule prevents investors from claiming investment losses if they purchase a substantially identical security within 30 days before or after the sale. It’s an important rule to know if you’re doing any kind of tax minimization, such as tax-loss harvesting.

The good news is that regardless of the wash-sale rule, it’s straightforward to manage your capital gains taxes and take advantage of your losses. However, if you ever aren’t sure how to reflect losses on your tax filings, a tax advisor or financial professional can help advise you on the safest course of action.