An important consideration when investing in a taxable investment account is the taxes you’ll eventually need to pay. The good news is there are strategies that may help you reduce your capital gains taxes.

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 may prevent you from deducting certain investment losses, which could result in a higher tax liability.

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

Identifying a wash sale

A common tax-minimization strategy for taxable investing is to sell assets at a loss to offset potential capital gains. This is known as tax-loss harvesting, which involves selling an investment at a loss for the purpose of offsetting capital gains on well-performing assets. 

You may also sell a losing investment to reduce your overall tax liability. The IRS allows you to claim capital losses up to $3,000 per year, which could help to offset other tax liabilities.¹ Excess losses can often be carried forward for use in future tax years, subject to IRS guidelines. 

Selling losing investments for the purpose of getting a tax benefit can easily enter a gray area if done incorrectly, however. If you sell your securities at a loss and then turn around and buy substantially identical securities within a certain time frame, this is considered a wash-sale.²

The IRS defines a wash as selling securities for a loss and, within 30 days before or after, doing 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 the potential misuse of tax benefits.

For example, consider this scenario: Suppose you sold ABC stock for a gain of $1,000, which would generally result in capital gains taxes. To offset this, 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 would not owe taxes on the net gain.

This approach is acceptable under IRS rules. However, suppose you took the money from your sale of XYZ stock and immediately repurchased the exact same stock. You would not have realized a financial loss since you would have repurchased the stock at the same or similar price.

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.³ This means you would not be able to deduct the loss immediately, but it could affect your tax treatment if you sell the securities in the future.

In the long run, this adjustment to cost basis may have positive implications. A higher cost basis could potentially reduce taxable gains or impact the calculation of future losses when the securities are sold again.

If you complete a wash-sale during the tax year, you’ll have to report it to the IRS. Form 849 is used to record these transactions, along with adjustments to your cost basis.

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, cryptocurrency currently falls outside of these rules, as we’ll discuss later.

Wash-sale rule across accounts

The wash-sale rule applies not only to individual taxable accounts, but it also extends across various account types. Understanding how the rule works in each context is critical to ensuring compliance and avoiding unintended consequences. Here’s a breakdown of key considerations:

Individual accounts

Wash-sales most commonly occur in individual taxable accounts. Investors may unintentionally trigger the rule by selling a security at a loss and then repurchasing it within 30 days. To avoid this, investors should track all trades carefully, particularly when engaging in tax-loss harvesting strategies. Using tax software or consulting a financial professional can help minimize errors.

IRAs

Wash-sales can have significant consequences if they involve an individual retirement account (IRA). If you sell a security at a loss in a taxable account and repurchase it in your IRA within the 30-day window, the loss is permanently disallowed.

What happens if you break the wash-sale rule? 

If the IRS determines that a wash-sale has occurred, the loss deduction is disallowed for that tax year. Instead, the disallowed loss is added to the cost basis of the repurchased security. This adjustment will affect the tax implications when you sell the security again in the future. Failing to report wash-sales accurately may also raise red flags with the IRS.

Spousal accounts

Transactions across spousal accounts can also trigger the wash-sale rule. For instance, if one spouse sells a security at a loss in their taxable account and the other spouse repurchases a substantially identical security within the wash-sale window, the rule applies. It’s essential to coordinate trades between spouses to avoid inadvertent violations.

Strategies to avoid wash-sales in interconnected accounts

Investor diligence is key to avoiding wash-sales across multiple accounts. Practical strategies include:

• Avoiding repurchases of the same or substantially identical securities across any of your accounts.
• Using different securities or diversified funds as replacements.
• Maintaining a detailed trade log to track all transactions and identify potential wash-sale triggers.

By understanding how the wash-sale rule applies across account types and implementing proactive strategies, investors can remain compliant while effectively managing their tax liabilities.

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 exact same security that you sold is a clear example of a substantially identical transaction. Additionally, preferred stock and a common stock of the same corporation might 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 considered substantially identical is if a company has gone through a reorganization or a merger. In these cases, the successor company’s securities might be deemed substantially identical to those of the predecessor company.

Given how subjective the determination is as to whether or not two securities are substantially identical, it’s best to consult with a tax advisor or financial professional to help avoid unintended violations.
 

Why does the wash-sale rule matter?

The wash-sale rule can have a significant impact on an investor’s ability to deduct capital losses when filing their taxes. Under normal circumstances, you’re able to offset your capital gains with losses, therefore reducing your tax liability. However, the wash-sale rule prohibits this if you purchase substantially identical securities within 30 days before or after the transaction.

Investors facing large tax bills could anticipate substantial financial implications from breaking the wash-sale rule. Noncompliance could lead to paying significantly more in taxes because they did not adhere to the IRS guidelines.

For example, suppose that several years ago, you purchased 500 shares of stock from a company for $50 per share — resulting in 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.

Simultaneously, suppose you hold another stock in your portfolio that has declined by $12,500. You sell the losing stock to offset the capital gains from your profitable sale. As long as you do not repurchase the exact stock within the 30-day wash-sale window, the IRS allows you to deduct those investment losses. However, if you repurchase the same stock within that window, the wash-sale rule disallows the deduction, potentially leaving you liable for a higher tax obligation.

Although there are exceptions to these rules, such as securities from different companies or certain common and preferred stocks, repurchasing the same common stock almost always triggers this rule. 

How to avoid a wash sale?

As an investor, it’s important to take steps to avoid wash sales, whether intentionally or unintentionally. The good news is that with the right precautions, it’s relatively easy to avoid triggering a wash sale. Here are a few strategies for staying in compliance with IRS guidelines.

Mind the 30-day rule

The most straightforward way to avoid a wash sale is to adhere to 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 at a loss. As long as you avoid purchasing substantially identical securities during the period spanning 30 days before, the day of sale, and 30 days after, you won’t be violating the rule.

Buy a different asset

You can still benefit from tax-loss harvesting without falling into the gray area of the wash-sale rule by purchasing a security that is not substantially identical to the one you recently sold.
For example, rather than repurchasing stock from the same company, consider investing in stock from a different company. The IRS does not typically view stocks from different companies as substantially identical to one another.

Invest in diversified funds

Another way to avoid the wash-sale rule is by investing in diversified funds like mutual funds and exchange-traded funds (ETFs). These funds provide exposure to a variety of securities, making it easier to stay within IRS guidelines.³

Consult a tax professional

If you’re uncertain whether two securities are considered substantially identical, it’s best to consult a tax professional. This can help you demystify whether or not you might be running afoul of the wash-sale rule, and what financial implications it may have for your investments.

Different types of securities can pose unique challenges when applying the wash-sale rule. Let’s look at how the wash-sale rule applies to some common investment types:

Bonds

The wash-sale rule treats bonds and stocks the same but can be more complicated with bonds. Since bond prices can fluctuate more frequently due to interest rate changes, determining whether a purchase is substantially identical to a previously sold bond can require a detailed analysis. 

For instance, repurchasing a bond from the same issuer within the 30-day window could trigger a wash sale if the bond is substantially identical in terms of characteristics such as maturity, coupon rate, or other factors.

Preferred stock

Preferred stocks present unique challenges to the wash-sale rule. Preferred stocks and common stocks from the same company may or may not be considered substantially identical, depending on the specific terms of the preferred stock.⁴ 

For example, if the preferred stock is convertible into common stock, this could create a situation where the two securities are viewed as substantially identical by the IRS. It’s crucial to evaluate each case individually when dealing with preferred stocks to avoid violating the wash-sale rule.

Complications for compliance

The nature of certain securities, such as bonds and preferred stocks, can complicate compliance with the wash-sale rule. Investors must be extra diligent because these securities may have different characteristics, as well as varying degrees of similarity to other securities. 

For example, if you sell one bond and repurchase a similar bond from the same issuer within the 30-day period, you could unintentionally trigger a wash sale.⁵ It's essential to carefully track the specifics of each trade to ensure compliance.

Tracking and managing trades 

Investors should keep detailed records of all trades, including the specific securities involved, purchase prices, and sale dates to avoid unintentional wash sales. Using tax software or working with a financial advisor can help ensure accurate tracking of investments, especially when dealing with complex securities. Regularly reviewing your portfolio and making sure you're not repurchasing substantially identical securities within the wash-sale window can help you avoid potential issues.

Is cryptocurrency subject to the wash-sale rule?

Cryptocurrency, as a digital asset, has introduced additional complexities to the tax laws. Despite its name, cryptocurrency isn’t a currency at all in the eyes of the IRS. Instead, it’s considered a form of property and is treated like other investments for tax purposes.⁶

Although cryptocurrency is subject to the same capital gains tax laws as stocks, bonds, and other assets, it is not subject to the wash-sale rule.⁷ This could be good news for cryptocurrency investors since it means they can sell and repurchase the same cryptocurrency within a 30-day period.

Tax regulations surrounding crypto are still evolving. There is ongoing debate among lawmakers regarding the treatment of cryptocurrency in relation to securities and tax regulations, which could affect future tax rules.⁸

If you’ve made cryptocurrency transactions, it is always advisable to consult with a tax professional when filing your income tax return.

Reporting wash sale losses

Reporting wash sale losses on your tax return is an important part of complying with IRS rules and ensuring accurate tax filings. Here’s how to report wash sale losses and understand their impact:

How wash sale losses are reported

When you complete a wash sale, you are required to report the loss on your tax return. This is done through IRS Form 8949, which is used to report the sale of capital assets.⁹ The wash-sale transaction is marked with a special code that indicates a disallowed loss due to the wash-sale rule. You will need to include this form with your tax return to accurately report the sale.

Impact on cost basis

One of the key aspects of a wash sale is how it impacts the cost basis of your repurchased securities. The disallowed loss is added to the cost basis of the newly purchased security when you sell a security at a loss and repurchase a substantially identical security within the 30-day window.¹⁰ This means that your cost basis for the new security will be higher than the purchase price, which could reduce your capital gains when you eventually sell it. Keeping track of these adjustments is crucial to avoid misreporting your future gains or losses

Impact on holding period

In addition to affecting your cost basis, a wash-sale also affects the holding period of the repurchased security. The IRS considers the holding period of the sold security to carry over to the newly purchased security.¹¹ This means that your holding period starts from the original purchase date, not the date you repurchased the security. This adjustment is important because the holding period affects whether your gains will be taxed at short-term or long-term capital gains rates. A longer holding period generally results in more favorable tax treatment, as long-term capital gains are taxed at a lower rate than short-term gains.

Practical tips for investors

Tracking wash-sales can be complicated, especially if you make multiple transactions throughout the year. One way to simplify the process is to use tax software, which can help automatically identify and track wash-sale transactions. Many tax software programs offer tools to help you correctly adjust your cost basis and holding period for these types of sales. Alternatively, you may want to consult with a tax professional who can help ensure that your tax filings are accurate and that you're complying with IRS regulations and addressing your specific tax situation.

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.