Heavy traders may assume they’ll owe no capital gains tax if their losses and gains even out. But then they stumble across the wash sale rule.
At the height of the pandemic born meme stock boom in 2021, the 50-something investor tried his hand as a day-trader, rapidly buying and selling stocks such as AMC Entertainment. In the end, he racked up more than $7 million in gains and just a hair over that in losses, resulting in what he thought was, more or less, a wash, taxwise.
But it wasn’t a wash, because of the too-often neglected “wash sale” rule, which holds that you can’t claim tax losses on a stock that you sell at a loss, if you purchase the same security (or a similar one) in the 30 days before or after the sale date. To the trader’s surprise, the IRS flagged over a half million dollars of his losses as “wash sales”—resulting in a six-figure tax bill for 2021 that he’s still paying off, even though he had lost money on his trading that year. (The investor, who has given up day-trading, now holds a conventional job and asked not to be identified.)
His experience provides a timely cautionary tale given that meme stocks have made something of a comeback this summer. One example is Opendoor Technologies, the real estate fintech whose stock hit nearly $40 a share in February 2021, during the last meme stock boom. It traded as low as 51 cents this past June, putting it at risk of delisting by NASDAQ. But in July, it surged more than fivefold to $3.21, driven higher by buzz on X and Reddit touting the company as the next big thing. (It closed yesterday at $1.95.)
These days, more individual taxpayers run the risk of running afoul of the wash sale rule thanks to the spread of commission-free stock trading (credit the pressure applied by fintech Robinhood); the ability to trade stocks from a smart phone app; and a younger generation that is far readier to rely on social media tips, including niche day-trading sub-Reddits, for investment advice. The latest World Economic Forum (WEF) survey of investors across the globe found that 57% of Gen Z and Millennials respondents ranked recommendations from social media or online communities as important vs. 37% of Gen X and just 20% of Baby Boomers. The WEF report, done in collaboration with Boston Consulting Group and Robinhood, estimated that since 2016, the number of users of stock trading apps has been growing at a compound annual rate of 20%.
If you’re one of those new users, you too could fall into the wash sale tax trap. Here’s a primer to keep you safe.
Capital Gains Tax Basics
Most taxpayers more or less understand the basics of capital gains and losses. You realize a gain or loss when you sell a security. If your realized gains are more than your realized losses, you have a taxable capital gain (the tax rate will depend on whether those gains or losses are long-term or short-term). In contrast, if your realized losses exceed your realized gains, you can claim up to $3,000 (or $1,500 if you are married filing separately) to offset your other taxable income. If your losses exceed the limit, you can carry the loss forward to later years, subject to some restrictions.
You figure your realized gain or loss by subtracting the basis of a security (generally, the cost that you paid) from the sale price. All of the activity in the middle is, for tax purposes, just a bunch of squiggly lines. The ups and downs may mess with your head—and your blood pressure—but they won’t hit your wallet until you’re ready to cash out.
That’s why advisors often suggest that you hold onto assets during periods of volatility. If and when the value goes back up, there are no tax consequences. But when you sell or otherwise dispose of the asset, you have a taxable event.
The basics above apply to securities held in regular taxable accounts, not to gains or losses that happen inside your retirement accounts. Losses and gains in your traditional IRA, Roth IRA or 401(k) don’t show up on your tax return. Instead, your withdrawals from a traditional pre-tax IRA or 401(k) are taxed later, at ordinary income rates. Retirement withdrawals from Roth IRAs are usually tax-free.
Wash Sale Rules
When you’re buying and selling stocks quickly, you may trade winners and losers within days of each other. If you’re not careful, you can easily run afoul of the wash sale rules.
A wash sale happens when you sell a stock or other security at a loss and then buy the same security—or a similar one—within 30 days before or after the sale. This rule applies to most of the investments in a typical brokerage account, including stocks, bonds, mutual funds, exchange-traded funds (ETFs), and options. (It does not, however, under current law, apply to the sale of crypto or NFTs. More on that below.)
Specifically, a wash sale is triggered if you do any of the following within a 61-day period:
- Buy a substantially identical stock or security;
- Acquire a substantially identical stock or security in a fully taxable trade;
- Enter into a contract or option to buy a substantially identical stock or security; or
- Acquire substantially identical stock for your IRA, Roth IRA or 401(k).
If you do any of those things within a 61-day period—beginning 30 days before the sale and ending 30 days after the sale—the wash sale rules will apply. (The extra day in the 61 days is the sale date.)
The wash-sale rule applies across all your accounts, so buying and selling inside one account can impact securities inside another account. And, importantly, the rule applies across calendar years, meaning that the clock remains ticking on a sale made on December 29 into the next year (you don’t get a pass for waiting until year-end to buy or sell).
The IRS isn’t particularly helpful when it comes to determining what makes a security “substantially identical.” IRS guidance suggests that you consider the facts and circumstances, which include some common-sense applications. Typically, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation (but in a reorganization, the stocks of the predecessor and successor corporations may be). If you can’t figure it out, or if you’re worried about inadvertently entering into a wash sale, consider waiting until the 30-day window has closed since the sale date.
So, what happens if a sale is considered to be a wash sale? The loss is disallowed, meaning you can’t use it to offset any capital gains. That can result in an ugly tax bill.
The Meme Stock Problem
Since the value of some stocks—especially meme stocks—may rise sharply, investors may be quick to hit the buy button. Often, those transactions are funded by selling other stocks, sometimes within minutes of each other or before the position is closed. Investors might also rely on margin trading. You can think of a margin like a line of credit since it’s typically money borrowed from the broker—investors post a sum as a deposit, but less than the full cost of a trade, to cover a large trade.
The result is sort of a perfect storm for the at-home investor. The access to quick cash (or leverage) means that you can buy and trade without worrying about funding, so long as you “make” as much as you “lose.” With some stocks, such as meme stocks, that may all happen very quickly. As shares start trending down, you may be tempted to offload them immediately and then buy them back again as the stock rebounds. That level of furious trading could land you back or close to your original position, even if you experienced significant losses along the way, which feels like a win. That is, until Uncle Sam steps in.
Then, like the former day trader in our story, you could find the IRS demanding money you don’t have.
It’s not all bad news. Any disallowed loss is added to the cost basis of the newly purchased stock, which means that when you sell that stock in the future, you may get a tax break. And, the holding period of the stock that you sold is added to the holding period of the new stock, which may result in the sale being treated as a long-term gain (meaning a gain on an asset held more than a year) at lower long-term capital gains rates. The top tax rate on a long term gain is 20%, or 23.8% if you are also subject to the net investment income tax (NIIT). Short-term gains are taxed as ordinary income, at a top rate of 37%, plus that nettlesome 3.8% NIIT.
Of course, that future tax benefit won’t necessarily help you settle an outstanding tax bill, but it may stop the bleeding for next year.
Your Intentions Don’t Matter
The wash sale rule has been around for almost as long as the modern tax system. The goal of the rule, which Congress first passed in 1921, was to “prevent taxpayers from taking colorable losses in wash sales and other fictitious exchanges.” At the time, the rule was fairly simple: If an investor sold a security at a loss and then repurchased the same or substantially similar security within 30 days, the loss would be disallowed. The “substantially identical” requirement wasn’t tacked on until 1954.
Today, buying and selling within a short time frame is done deliberately as part of a strategy that some taxpayers use to reduce their tax bill. Sometimes referred to as tax-loss harvesting, the goal is to sell stocks that are losing money and use the loss to offset the money-makers. That still works, so long as you don’t run afoul of the wash sale rules.
But, importantly, the transaction doesn’t have to be intentional to trigger the wash sale rule. Dividend reinvestment and employee stock plan acquisitions may create a wash sale, as could buying and selling quickly.
You can’t avoid the rule by relying on tax-favored accounts. If you dump stock in your brokerage account and then re-buy it inside of a retirement account, the rule still applies.
And, the IRS takes the position that if you sell stock at a loss and it’s repurchased by your spouse, that also results in a wash sale (the same rule applies to a corporation that you control).
Exceptions
Not all sales are subject to the wash sale rules—remember, the rule applies to securities. That means that—for now—the wash sale rule doesn’t apply to crypto trading since, for tax purposes, crypto isn’t considered a security. However, it’s worth noting that the new Form 1099-DA requires reporting of disallowed wash sales on line 1i. That could apply to assets like tokenized stocks (equity in a publicly traded company in a digital token form)—but may also be a nod towards future proposals that would ban crypto wash sales altogether (again, that’s not currently the law).
Wash sales also do not apply to professional traders (not at-home retail investors) who use the mark-to-market accounting method (with mark-to-market, gains and losses are generally treated as ordinary gains and losses). The rules also don’t apply to securities dealers with losses from transactions made in the ordinary course of business.
How Will The IRS Find Out?
The IRS requires brokers to track and report wash sales that involve stocks, bonds, and most other common securities covered by the cost basis reporting rules if they occur on the same security and within a single account. You’ll see this information on your Form 1099-B (line 1g), the same form that your broker issues to report your dividends and interest, as well as your other sales.
Remember: The rule applies to all of your accounts. If you have more than one broker, not all of your wash sales may appear on a single Form 1099-B. Transactions made through other platforms may not be reported as wash sales even if they are taxable as such, because platforms don’t share that kind of information with each other. That’s why you need to keep good records and double-check at tax time to see whether your transactions might count as wash sales. Or better yet, avoid wash sales when you trade. The rules involving wash sales and a lot of other tax rules too, are complex, so even when you’re aware of them, it’s easy to fall into a tax trap. A financial or tax advisor may be able to help you avoid the pitfalls—and a hefty tax bill.
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