Wash Sales (Internal Revenue Code Section 1091)
The wash sale rule prevents investors from claiming a tax loss while essentially keeping the same investment. If you sell at a loss and quickly buy back the same security, the IRS disallows the loss.
The Wash Sale Rule
A wash sale occurs when a taxpayer:
- Sells a security at a loss, AND
- Purchases a substantially identical security within 30 days before or 30 days after the sale
The total wash sale window is 61 days: 30 days before + the sale date + 30 days after.
When a wash sale occurs:
- The loss is disallowed for tax purposes (you cannot claim it on your return)
- The disallowed loss is added to the cost basis of the replacement security
- The holding period of the original security tacks on to the replacement security
The loss is not gone forever. It is deferred by being built into the new shares' basis.
Exam Tip: Gotchas
- The total wash sale window is 61 days, not 30. Count 30 days before the sale + the sale date itself + 30 days after. A purchase on either side of that window triggers the rule.
Substantially Identical Securities
Not every purchase within the 61-day window triggers the rule. The key question is whether the securities are substantially identical:
| Action Within 61 Days | Triggers Wash Sale? |
|---|---|
| Buy the same stock | Yes |
| Buy a call option on the same stock | Yes |
| Buy a different stock in the same industry | No |
| Buy shares of a mutual fund holding the same stock | Generally no |
| Buy a convertible bond of the same issuer | Potentially yes |
Exam Tip: Gotchas
- Buying a call option on the same stock triggers the wash sale rule. Options on the same underlying security count as substantially identical, even though you did not buy the stock itself.
- Buying a different stock in the same industry does not trigger it. Only substantially identical securities count, not just similar ones.
Cost Basis Adjustment
When a wash sale occurs in a taxable account, the disallowed loss gets added to the replacement purchase:
New cost basis = purchase price of replacement shares + disallowed loss
Example:
- Sell 100 shares at a $500 loss
- Repurchase 100 shares within 30 days at $4,000
- Wash sale triggered: loss is disallowed
- New cost basis = $4,000 + $500 = $4,500
- If you later sell at $5,000: taxable gain = $5,000 - $4,500 = $500 (instead of $1,000)
Think of it this way: The loss is not gone; it is baked into the new shares. When you eventually sell the replacement shares, the higher cost basis reduces your taxable gain by the same amount the disallowed loss would have.
Exam Tip: Gotchas
- Wash sale losses in taxable accounts are deferred, not eliminated. The disallowed loss increases the replacement shares' cost basis, so the tax benefit is recovered on a future sale.
IRA Purchases: Permanently Disallowed Losses
The wash sale rule applies across all accounts the taxpayer controls, including taxable accounts, IRAs, and even a spouse's accounts.
Here is the critical distinction:
| Replacement Purchase Location | What Happens to Disallowed Loss |
|---|---|
| Taxable account | Loss added to new cost basis (deferred, not lost) |
| IRA or Roth IRA | Loss is permanently disallowed (gone forever) |
Why does this happen? You cannot adjust the cost basis inside an IRA. IRA distributions are taxed as ordinary income regardless of basis, so the disallowed loss has nowhere to go.
Example:
- Sell stock at a $2,000 loss in your taxable brokerage account
- Buy the same stock in your IRA within 30 days
- The $2,000 loss is permanently lost (you can never deduct it)
Exam Tip: Gotchas
- Taxable account = deferred loss; IRA = permanent loss. In a taxable account, the disallowed loss increases the replacement shares' basis. In an IRA, the loss is gone forever because IRA cost basis cannot be adjusted.
- The rule applies across accounts. Selling in a taxable account and repurchasing in an IRA (or a spouse's account) within 61 days still triggers a wash sale.