How to Avoid Violating Wash Sale Rules When Realizing Tax Losses

Tax-loss selling is an investment strategy that can help an investor reduce their taxable income for a given tax year. Tax-loss selling involves selling a security that has experienced a capital loss in order to report it as a capital loss when filing yearly income taxes, and thus lower or eliminate any capital gain that may be realized by other investments.

To successfully realize the loss for tax purposes, you must liquidate the position during the tax year. Any unrealized loss on an investment cannot be deducted from your income taxes.

Sometimes an investor will decide to replace that security with a similar security, allowing them to maintain a consistent, optimal asset allocation and achieve their desired returns. If you take this approach, it is important to be mindful that you do not accidentally trigger a wash sale in your investment account.

What Is a Wash Sale?

A wash sale occurs when you sell or trade a stock or securities at a loss, and within 30 days of the sale (either before or after), you purchase the same—or a "substantially identical"—investment. The wash-sale rule is a regulation established by the Internal Revenue Service (IRS) to prevent taxpayers from claiming artificial losses to maximize their tax benefits.

When a wash sale occurs in a non-qualified account, the transaction is flagged, and the loss is added to the cost basis of the new, "substantially identical" investment you purchased. If you continue to trade the same investment, the loss gets carried forward with each transaction until the position has been fully liquidated for more than 30 days.

The same rules apply if the spouse of the individual that sells the security, or a company controlled by that individual, purchases the same or substantially equivalent securities within the 30-day timeframe.

In addition, your holding period for the new stock or securities (for designating whether or not the investment will represent a short- or long-term capital gain) includes the holding period of the stock or securities that were previously sold.

Investments Subject to Wash Sale Rules

The wash-sale rule applies to stocks or securities in non-qualified brokerage accounts and individual retirement accounts (IRAs). The sale of options at a loss and the reacquisition of identical options within a 30-day timeframe would also violate the wash-sale rule.

IRS Publication 550 provides guidelines about what is considered a "substantially identical" investment and what may trigger a wash-sale violation. A substantially identical investment can include new and old securities issued by a corporation that has undergone reorganization or convertible securities and common stock of the same company.

When an investor holds several different investment accounts, wash-sale rules apply to the investor, rather than a specific account. The IRS requires that brokers track and report any sales of the same CUSIP number in the same non-qualified account. However, investors are responsible for tracking and reporting any sales that occur in all other accounts they control, including any accounts belonging to their spouse.

Offset Capital Gains Through Tax-Loss Selling

While some investors turn their attention to tax-loss selling towards the end of the calendar year, it is possible to use this strategy throughout the year to capture tax losses through rebalancing or replacing positions in your portfolio. Capital losses are used first to offset capital gains. After this, up to $3,000 per year can be used to offset other taxable income for an individual filer or married couple filing jointly (up to $1,500 for married filing individually), for 2023 and 2024.

For example, an investor realizes $2,000 in short-term capital gains and $5,000 in short-term capital losses for the same tax year. At the time they file their income taxes, they can offset the full amount of capital gains and $3,000 from their ordinary income. Depending on their state of residence, the investor may also be eligible for a reduction in their state taxes. Any remaining capital losses can be carried forward to future tax years. Unfortunately, losses cannot be transferred at death.

Strategies for Avoiding Wash Sales

There are strategies for avoiding wash sales while still taking advantage of taxable gains and losses. If you own an individual stock that experienced a loss, you can avoid a wash sale by making an additional purchase of the stock and then waiting 31 days to sell those shares that have a loss. A potential drawback of this strategy is that it can increase your market exposure to a given sector and could potentially increase your risk.

In this same situation, an investor may decide to liquidate the holding, recognize the loss, and then immediately buy a similar investment that will also satisfy their investment goals or portfolio allocation. For example, an investor may decide to sell their stock of The Coca-Cola Company (KO) and then immediately purchase a similar investment of PepsiCo, Inc. (PEP).

Similarly, an investor may decide to sell their shares of the Vanguard 500 Index Fund (VFIAX) and replace them by purchasing shares of the Vanguard Total Stock Market ETF (VTI).

The Bottom Line

A wash sale is when an investor sells a security in their portfolio and, within 30 days, buys a new or substantially identical version of the same stock. This method is employed as a means of lowering the investor's taxable income. To avoid triggering the wash sale rule, an investor can employ a strategy such as buying more of the stock that they'd like to sell, holding on to the new stock purchase for 31 days, and then selling it. An investor could also sell a stock at a loss, register the loss, and then buy a similar investment.