Understanding Wash Sale

Awash sale is a transaction in which an investor seeks to maximize tax benefits by selling a losing security at the end of a calendar year so they can claim a capital loss on taxes that year. The investor’s intent is likely to repurchase the security again after the start of the New Year, if possible even lower than where they sold. Such wash sales are a method investors have historically considered to recognize a tax loss without limiting their exposure to opportunity they perceive in owning a particular security. The IRS uses the wash-sale rule to eliminate the incentive to arbitrarily sell and reacquire the same security around the end of the calendar years.

A wash sale works when a country’s tax laws permit tax deductions for losses on securities held within a given tax year. Without such incentives there would be no need for wash sales. However where such incentives exist, wash sales inevitably result. The wash sale has three parts.

First, when investors notice they are in a losing position at the end of a tax year, they close that position at or near the end of the year. Second, the sale allows them to take a loss that they can legally claim on their tax returns as a reduction of their earnings for that year. Third, after the New Year begins, the investor will look to purchase the security at or below the price they sold previously.

To prevent the abuse of this incentive, the Internal Revenue Service (IRS) instituted the Wash-Sale Rule in the U.S. (In the U.K. the practice is known as bed-and-breakfasting and the tax rules in the U.K. have an implementation similar to the Wash Sale Rule). The rule designates that if an investor buys a security within 30 days before or after having sold it that any losses made from that sale cannot be counted against reported income. This effectively removes the incentive to do a short-term wash sale.

For example, let’s assume an investor has a $15,000 capital gain from the sale of ABC stock. He falls in the highest tax bracket and so will have to pay 20% capital gains tax, or $3,000, to the government. But let’s say he sells XYZ security for a loss of $7,000. His net capital gain for tax purposes will be $15,000 - $7,000 = $8,000, which means he’ll have to pay only $1,600 in capital gains tax. Notice how the realized loss on XYZ reduces the gain on ABC and, hence, reduces the investor’s tax bill.

Investopedia