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The Tax Guy by Bill Bischoff (Author Archive)
A Sneaky New Twist on the Wash-Sale Rules
(Page all of 2)
WHEN YOU SELL a bad securities investment, the one saving grace is that you can at least claim a capital loss deduction, right?
Not necessarily. In fact, all or part of your capital loss deduction will be disallowed for federal income tax purposes if the dreaded wash-sale rule applies. And thanks to some recent IRS guidance, you now have to worry about IRA transactions triggering a wash sale problem, too. Here's an update on how the wash-sale rule works:
The Basics of Wash Sales
Your personal investment loss cannot be claimed as a capital loss for federal income tax purposes if, within the period that begins 30 days before the date of the loss sale and ends 30 days after that date, you buy "substantially identical" stock or securities (including mutual fund shares). The theory is that the loss sale and the offsetting purchase of substantially identical securities within the forbidden 61-day period amount to an economic "wash." As a result, our beloved tax law says you aren't entitled to the tax benefit that you'd otherwise get from the loss.When you have a disallowed wash-sale loss, it doesn't just vaporize (except when an IRA is used to acquire substantially identical securities, which I'll explain later). Instead, the disallowed loss gets added to the tax basis of the acquired securities — the ones that triggered the wash-sale rule in the first place.
Then, when you sell those securities, the extra basis from the disallowed wash-sale loss either reduces your tax gain or increases your tax loss. In effect, the disallowed loss is converted into a "built-in loss" that will be taken into account when you sell the substantially identical securities. By the same logic, your holding period for the substantially identical securities is increased by the period you held the securities for which the loss was disallowed.
Example: Say you bought 1,000 shares of Acme Bank on Jan. 2 for $20,000 and then the shares began to plummet. Being a tax-smart person (or so you thought), you bailed out on July 10 for a paltry $12,000. As a result, you have an indicated $8,000 short-term capital loss ($20,000 basis - $12,000 sales proceeds). You intend to use that loss to shelter an equal amount of 2008 capital gains. Having bagged your tax savings (or so you thought), you then reacquire 1,000 shares of Acme Bank on Aug. 1 for $11,000. Sadly, you are blissfully unaware of the wash-sale rule, which disallows the $8,000 tax loss you were expecting. Now, the disallowed loss is added into the equation, increasing the tax basis of the new Acme Bank shares you acquired on Aug. 1 to $19,000 ($11,000 to buy the shares + $8,000 for the disallowed loss). In addition, the holding period for those shares is increased by the six-plus months you held the original Acme Bank shares.
Acquiring Substantially Identical Securities Using an IRA
Say you use a traditional or Roth IRA to buy substantially identical securities shortly before or after a loss sale. Does that trigger the wash-sale rule? For years, the IRS had nothing to say about this. However, in recently-released Revenue Ruling 2008-5, the IRS suddenly opined that using an IRA to buy substantially identical securities within the forbidden 61-day period triggers the wash-sale rule. Even worse, the IRS says you cannot increase your tax basis in the IRA by the amount of the disallowed loss. This newfound IRS wisdom relies on an ancient 1933 court decision regarding a circumstance where substantially identical securities were acquired by a taxable trust controlled by the taxpayer. In my opinion, it's beyond a huge stretch of logic to say that this means an IRA transaction can trigger the wash-sale rule, but nobody at the IRS checked with me. While I think the IRS is off base here, it's probably not worth the risk to ignore the Feds.Wash-Sale Rule Gray Areas
Would the IRS also argue that the wash-sale rule is triggered if you use your 401(k) or other tax-advantaged retirement account to acquire substantially identical securities within the forbidden 61-day period? We don't know since the government has yet to address this specific situation. However, given the recent ruling on IRAs, it's not looking good.
Say you sell stock for a loss, and your spouse buys identical stock within the forbidden 61-day period. The wash-sale rule would clearly apply if you file jointly. Fair enough. However, IRS Publication 550 says the wash-sale rule would apply even if you and your spouse file separate returns — although there doesn't appear to be anything backing up the government's opinion. Nevertheless, ignore it at your own risk.
According to IRS Publication 550, the wash-sale rule should also apply when substantially identical securities are purchased by a corporation under your control. However, the government's opinion is apparently based on an ancient 1935 court decision that may or may not have any validity in today's world. Once again, ignore it at your own risk.
The Bottom Line
Keep in mind that the current unsettled investment climate increases the odds of the wash-sale rule rearing its ugly head — since so many folks have losing positions. Before selling for a hoped-for tax loss, however, try to avoid transactions that would trigger the wash-sale rule — and be aware that the IRS is trying to cast a wider net when it comes to this area of the tax law.For more details on the wash rule, see our story Understanding the Wash-Sale Rules.
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Posted: 1:04 AM EST June 13, 2009
Posted by: rvirzi
>>For example, sell in the Roth at a loss of $500, then buy the same stock the same day in a taxable account for $1000; later when I sell in the taxable account, is my basis $1000 or $1500?<<
Since the IRS rules do not specify, I believe it is safest to simply use the $1000 purchase price and forfeit the $500 write down. Otherwise you'd have to explain where the added basis comes from.
Posted: 11:41 PM EST June 12, 2009
Posted by: sgsg
What about the reverse situation, where a stock is sold in a Roth IRA at a loss and then bought in a taxable account within 30 days? Is the loss amount added to the cost basis in the taxable account? For example, sell in the Roth at a loss of $500, then buy the same stock the same day in a taxable account for $1000; later when I sell in the taxable account, is my basis $1000 or $1500?
Posted: 3:46 PM EST August 09, 2008
Posted by: rvirzi
Straight from the IRS Ruling: 'This ruling provides that if an individual sells stock or securities for a loss and causes his or her IRA or Roth IRA to purchase substantially identical stock or securities within a specified period, the loss on the sale of the stock or securities is disallowed under section 1091 of the Code, and the individual's basis in the IRA or Roth IRA is not increased by virtue of section 1091(d).' Thanks for looking that up for us. Now we see that this rule is really targeted at Roth IRA's. Before the rule, you could sell stock while it was down and take a write-off, then re-buy in your Roth IRA and not pay taxes on any subsequent gains. Now you just don't take the write-off and all is fair because it's as if you just transferred the asset into your Roth and are pretending you bought it in the Roth to begin with.
With a traditional IRA (or 401K), before the rule you could escape the wash sale rule and use it for early tax write-offs in a year w...(Read more of this comment)
Posted: 7:35 AM EST August 09, 2008
Posted by: lisanne5
DISREGARD MY LAST POST. I missed some edits. This one makes more sense!With regard to what constitutes 'substantially identical' securities in the world of ETF's and mutual funds, the IRS has not made a specific ruling on this (yet). A S&P 500 mutual fund from one company and a S&P 500 mutual fund from another company would be 'substantially identical' since they own the exact same stocks. Any actively managed fund would be unique in my opinion (and not 'substantially identical' to another), even if they both have the same general type of securities -- for example large cap domestic stocks. We'll have to wait for the IRS to be more specific on this. In the meantime, it pays to play it safe. Keep those sales and purchases of potentially identical funds more than 31 days apart.
Posted: 7:32 AM EST August 09, 2008
Posted by: lisanne5
With regard to what constitutes 'substantially identical' securities in the world of ETF's and mutual funds, the IRS has not made a specific ruling on this (yet). The wash-sale rule apparently applies to securities. For instance, you can't sell A S&P 500 mutual fund from one company and another S&P 500 mutual fund from some other company would be 'substantially identical' since they own the exact same stocks. Any actively managed fund would be unique in my opinion (and not 'substantially identical' to another), even if they both have the same general type of securities -- for example large cap domestic stocks. We'll have to wait for the IRS to be more specific on this. In the meantime, it pays to play it safe. Keep those sales and purchases of potentially identical funds more than 31 days apart.
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