What is the IRS Wash Sale Rule?

Generally, when a taxpayer sells stock or securities for a loss, a deduction is allowed on the loss. However, the Wash Sale Rule is an Internal Revenue Service (“IRS”) anti-abuse rule that disallows a loss deduction on the sale of “shares of stock or securities” when, within the specified statutory time period, the taxpayer obtains—or contracts to obtain—“substantially identical stock or securities.” 

The Wash Sale Rule seeks to stop taxpayers from taking advantage of a loss on paper when in reality the taxpayer quickly replaced the sold stock or securities with identical stock or securities. When determining whether the Wash Sale Rule applies, taxpayers will want to ask themselves five initial questions, detailed below.

Is the taxpayer subject to the Wash Sale Rule?

The Wash Sale Rule applies broadly to almost every type of taxpayer. The rule applies to individuals, corporations, banks, trust companies, life insurance companies, trusts, estates, day traders, and so on. However, the rule specifically exempts dealers of stock or securities if “the loss is sustained in a transaction made in the ordinary course of such business.” In other words, a dealer of stock or securities may incur a loss even if the rule would otherwise apply so long as the transaction is a natural, non-fraudulent result of the dealer’s everyday business dealings. Notably, a dealer will still be subject to the Wash Sale Rule if the transaction is determined to lack any economic substance and was done for tax avoidance purposes.

Additionally, attempting to use a related party—such as a spouse, a trust, or a controlled corporation—to avoid the Wash Sale Rule will still result in the disallowance of the loss. 

Wash Sale Example:A taxpayer sells stock at a loss and then orders her broker to repurchase the stock on behalf of her spouse, the loss will likely be disallowed. Similarly, a taxpayer selling stock and having a corporation that she has a controlling interest repurchase the stock will result in the loss being disallowed.

Has a loss occurred?

A loss must occur for the Wash Sale Rule to apply. While this may seem intuitive, it is important to confirm that a loss has occurred (as opposed to a gain on the sale of stock or securities). The Wash Sale Rule only applies to losses. If a wash sale results in a gain, the gain is simply taxable in the year the sale occurs and the Wash Sale Rule is not applicable.

Did the loss result from the sale of “stock or securities?”

The Wash Sale Rule provides that the loss must result from the sale of “stock or securities.” The Wash Sale Rule does not provide a definition for what constitutes a stock or security. Courts, the IRS, and other government agencies rely on the plain meaning of the term “stock or security,” along with the anti-abuse intent of the Wash Sale Rule, in order to shed light on the meaning of “stock or security.” The most common instrument taxpayers think of when considering the Wash Sale Rule are publicly traded stocks. However, the Wash Sale Rule applies to more than just publicly traded stocks.

In addition to a corporation’s stock, there are several other types of financial instruments subject to the Wash Sale Rule. Below are some examples of what has been considered “stock or securities” for purposes of the Wash Sale Rule:

• Bonds
• Mutual Funds
• Options or contracts to buy or sell stock or securities
• Exchange Traded Funds

IRA and Roth IRA stock purchases – the IRS determined in Rev. Rul. 2008-5 that an IRA’s purchase of substantially identical stock or securities triggers the Wash Sale Rule.

Outside of the instruments or accounts listed above, many of the most common investment tools are not subject to the Wash Sale Rule. For example, commodities futures are not included under the definition of a “stock or security” for purposes of the Wash Sale Rule. Nor are foreign currencies or certificates of membership on an exchange. Swaps, caps, floors, collars, and similar principal contracts will also not fall under the definition of stock or securities because these are privately negotiated and not freely transferable.

Does the Wash Sale Rule Apply to Cryptocurrency?

Currently, the Wash Sale Rule does not apply to cryptocurrency, and neither Congress nor the IRS has issued any guidance regarding the application of the Wash Sale Rule to crypto. However, recent proposed legislation has included a Wash Sale Rule for crypto. Additionally, government agencies—such as the IRS and the SEC—have been taking a closer look at cryptocurrency and the lack of regulation when compared to other investments. Current and prospective investors in cryptocurrency will want to consult with their tax advisor about current and future Wash Sale Rule application to any investments in crypto.

Did the taxpayer obtain substantially identical stocks or securities?

The Wash Sale Rule does not provide an explicit definition for what “substantially identical” means. In order for stock or security to be considered substantially identical, they must be from the same issuer; stocks or securities from different issuers are not considered substantially identical. In order to determine if stock or security from the same issuer is substantially identical, taxpayers will need to compare the stock or securities key (or “material”) features, such as the interest rate, maturity date, voting rights, preference rights, and so on. If these key features are the same for both the asset sold and the new asset obtained, they will be considered “substantially identical.” Small, immaterial differences—such as when their payment dates occur or a minor difference in maturity date—will not affect whether a stock or security is considered substantially identical. Determining if a stock or security is substantially identical is based on a factual comparison of the instruments, and taxpayers will want to consult their tax advisors to confirm if the stock or security at issue will be considered substantially identical. As noted above, if substantially identical stock is obtained by the taxpayer’s IRA or Roth IRA, the Wash Sale Rule is triggered and any loss is disallowed.

Were the identical stocks or securities obtained within the Wash Sale Rule’s statutory timeframe?

The Wash Sale Rule applies only when the identical stock or securities are obtained within either 30 days prior to or 30 days after the sale of the original stock or securities. This time frame creates a 61-day window where the Wash Sale Rule applies, with the sale of the original stock occurring right in the middle of the window. Importantly, the purchase of new, identical stock does not need to occur after the sale of the original stock; rather, the purchase of the new stock can occur at any time during the 61-day time frame. Taxpayers who wish to avoid the Wash Sale Rule may simply wait the required amount of time and, once the 61 days have passed, proceed with purchasing new stock regardless of whether it is “substantially identical.”

Conclusion

The Wash Sale Rule applies broadly to almost all taxpayers but is narrow in its application to only specific stocks and securities. Taxpayers will want to review the five questions discussed above to ensure that they are accurately complying with the Wash Sale Rule while also working to actively and efficiently plan around the rule. Learn how you can navigate the wash sale rule and other tax regulations by requesting a demo today!