Wednesday, February 6, 2013

Wash Sales – A Clean Explanation

More and more people are trying their hand at trading securities through online websites.  If you are one of those people, the wash sale rule is something you may want to be aware of.

A wash sale occurs when a taxpayer sells a stock or security for a realized loss, and within 30 days before or after the day of the sale (a 61-day period), the taxpayer purchases “substantially identical” stocks or securities.  For example, let’s say I am a stockholder of a popular retail chain named Small-Mart. Small-Mart has had a slow year and their stock is down, so I decide to dump it.  A few weeks later I read they are acquiring a competitor named Jay-Mart.  Jay-Mart is a large, well-managed competitor, so I think the future of the new consolidated company is bright and I decide to look into adding the stock back into my portfolio.  If I repurchase the stock within 30 days of previously selling it at a loss, a wash sale has occurred.

When a wash sale occurs the loss on the original sale is disallowed.  Rather, the amount of the would-be “loss” is added to the basis of the newly purchased stock – essentially deferring it for future recognition.  The acquisition date for the subsequent purchase is adjusted back to the acquisition date of the original stock purchase.   It’s as if the sale and repurchase of the stock never even occurred!

In order for the sale to be considered a wash sale the stock or securities must be substantially the same, which usually means from the same corporation.  Therefore selling off a stock of one computer manufacturer for a loss and subsequently purchasing the stock of another computer manufacturer within 30 days does not result in a wash sale.  However, in cases such as acquisitions or reorganizations (as in the example above) the stocks may be considered substantially identical, depending on the facts and circumstances.  Usually bonds or preferred stock are not considered substantially identical to the common stock of the same corporation – unless the bond or preferred stock is convertible into common stock of that same corporation.

There are some exceptions to the rule that you should be mindful of.  Specifically, stock or securities acquired as a result of a nontaxable exchange, like-kind exchange, inheritance, or divorce settlement do not fall under wash sale rules.

Brad Williamson