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Why Should You Care About Wash Sale Rules?

In many of the presentations that I give I am often asked about the wash sale rule. Traders and investors both want to know what the definition of a wash sale is and how it affects their tax liability.

Wash sale defined: In simple words the wash sale rule is an Internal Revenue Service (IRS) rule prohibiting a taxpayer from claiming a loss on the sale of an investment when the same investment was purchased within 30 days before or after the sale date. Your anticipated tax loss is disallowed if, within the period beginning 30 days before the date of the loss sale and ending 30 days after that date, you acquire “substantially identical” stocks or securities.

According to the tax law, your loss transaction and the purchase of the replacement securities are a “wash,” not allowing you any tax benefits. However, if you sell for a gain and buy back identical stocks or securities within the above time frame, Uncle Sam is happy to collect his “cut of the action.” Options are included in the definition of stocks and securities; therefore you can also have a wash sale when you sell options at a loss.

For the wash sale rules to come into play, the stocks or securities must truly be substantially identical. Stocks or securities issued by one corporation are not considered substantially identical to stocks or securities of another. You should also be careful selling one S&P 500 Index fund for a loss and then buying into another S&P 500 index fund within 30 days. It may be considered a wash sale by the mighty IRS. Short sales are also subject to the wash sale rule but futures contract and foreign currencies are excluded.

Trying to be “creative” with avoiding the wash sale rule like having your spouse sell a stock followed by a purchase from you or your controlled corporation or your IRA account will not succeed. The IRS will deem it as a wash sale resulting in a deferred tax loss or a disallowed loss.

Once a transaction’s loss is deferred because of the wash sale rule, the basis of the stock currently held is adjusted upward by the amount of the deferral. The next transaction involving that share utilizes the new higher adjusted tax-basis. Therefore, if the entire position is subsequently liquidated and you further remain out of the stock for the next 31 consecutive days, the entire deferred loss will generally be recognized for tax purposes through the increase in basis used to compute the final gain or loss. However, if you re-enter the position within the 31 following days you may again find the wash sale rule comes into play. For active traders this can go on and on and on causing you to spend time figuring out if your cost basis is accurate and if you accurately claimed your gains and losses.

IRS Story. I would like to share with you a case I encountered. An active trader who came to us for tax consulting was showing at year end a loss of about $7,500. The client had been audited by the IRS due to failure to report wash sales. The IRS wanted to claim the loss on the following tax year which led the client to report a capital gain of $250,000, creating a tax liability of more than $80,000! The IRS further charged this client more than $20,000 in interest and penalties! (It took them only 18 months to complete the audit.)

A way out. Wash sale rules can have a huge effect on your tax liability whether you are an investor or an active trader.  There are a few ways around the wash sale rule.

The first way is to count 31 days before exiting a transaction. Obviously this is not very practical for most active traders.

The second way is don’t trade stocks/options.  But if you do this, you will be missing out on two asset classes that are the foundation of the financial markets.

Third, trade futures/commodities/foreign currency, etc.  If you are not familiar with trading these asset classes, contact your nearest Online Trading Academy Center to check into additional trading education on these assets.

The real way out is to make the mark-to-market election as it eliminates the need to report wash sales (be sure to read my article on mark-to-market). The deadline to make the mark-to-market election for your individual return is April 15, 2012.  We strongly suggest you consult with a tax professional before making this election as it is an irrevocable election (for the duration of your life).

If you want to have more flexibility than an election that will last a lifetime we suggest consulting with one of our OTA Tax Pros professionals and considering setting up an entity to trade through. The entity provides the ability to make the mark-to-market election at the inception of the business even if it’s after April 15th, and if you want to back out of this election, you can simply dissolve the company.

Last Word. Don’t let the IRS dictate your style of trading. Take control over your trading and over your tax liability. Contact us today to find how best to stand up to the IRS.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.