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A "wash sale" is when an asset, usually a security, is sold and then bought back within a short period of time. The usual reason this is done is so that the owner can take a loss on their income taxes for a decline in the value of the asset, but still hold on to the asset. In a sense, they're "washing out" the old value and replacing it with a new value, and taking the difference as a tax writeoff.

Suppose, for instance, you buy stock worth $50,000. The stock falls in value to $20,000. You sell it for $20,000, recognizing a $30,000 loss for tax purposes, and then buy back the stock a few days later for $25,000. While you lost $5,000 in the wash sale, your income for tax purposes is reduced by $30,000 to account for the decline in the stock's value, and you probably make some money back when you file your tax return.

The problem with this strategy is that the stock now has a basis of $25,000 instead of $50,000. This means that if the value goes up to $35,000 and you sell the stock, you owe taxes on a gain of $10,000: if you hadn't gone through the wash sale, you would have a loss of $15,000 instead. So a wash sale can be thought of as an attempt to "hurry up" a loss; if you want to write off the loss immediately but don't want to give up the property, it's a decent strategy.

However, the U.S. Internal Revenue Service has a "wash sale rule" (Section 1091 of the Internal Revenue Code) which prohibits taxpayers from taking losses on any sale of securities followed by a buyback of substantially similar securities within 30 days. Instead, the basis of the securities is changed by the difference between the "before" and "after" prices in the wash sale. In the above example, the original value of $50,000 would be increased by $5,000, the difference between the sale price of $20,000 and the buyback price of $25,000. This means that the $5,000 spent in the transaction gets added to the loss, or subtracted from the gain, when the stock is ultimately sold.

There are other ways for American taxpayers to use wash sales as a tax trick. For instance, a taxpayer is still allowed to take a gain on a wash sale. Say the stock in the example above, bought for $50,000, is now worth $75,000... but it's been a bad year and you're taking $30,000 in unrelated losses on your taxes. By selling the stock and then buying it back, you realize a gain of $25,000, which brings the total loss for the year down to $5,000. Then, if the stock goes up to $100,000 over the next few years, you can sell it again, and your gain is only $25,000, even though you've made a $50,000 profit on the stock. This type of wash sale lets the taxpayer bury part of their gain in an unprofitable year, and thus make their taxes in a more profitable year much lower.

Another useful exception to the IRS's rule is that the securities in a wash sale must be "substantially identical." This means that you can sell your $50,000 stock for $20,000, take the loss on your taxes, and use the proceeds from the sale to buy stock in another company. You get the tax write-off, and you still have similar (but not substantially identical) assets.

Obvious disclaimer: Don't rely on pseudonymous authors for tax advice.

Wash sale. (Stock Exchange)

A sale made in washing. See Washing, n., 3, above.

 

© Webster 1913

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