If you’re an experienced investor, you’re probably familiar with the “wash sale” rule. Under Section 1091 of the Internal Revenue Code, you can’t deduct a loss from the sale of securities if you reacquire substantially identical securities within 30 days of the sale. While the law isn’t crystal clear on what constitutes “substantially identical” securities, buying shares of other companies in the same industry as the stock you sold should not cause problems. So if you sell stock in one computer maker and immediately put the proceeds into another computer manufacturer, it shouldn’t trigger the wash sale rule.
Still, it’s always a good idea to keep the rule in mind, and it’s especially important this year. Be aware of several tax law changes taking effect in 2013 that may affect securities sales. Significantly, the maximum tax rate on net long-term capital gain increases from 15% to 20% for single filers with income above $400,000 and joint filers with income above $450,000., Also, a top tax rate of 39.6% is added for ordinary income (including short-term capital gains) above the same income thresholds. And if your income exceeds other specified levels, a new 3.8% Medicare surtax may apply to some or all of your investment income.
When you add up all these tax increases, you could face an effective tax rate as high as 43.4% in 2013! That makes it all the more important not to forfeit any current losses under the wash sale.
Several tried-and-true strategies may help you avoid or minimize negative tax results under the wash sale rule. Here are four possibilities to consider:
1. The waiting game. Suppose you acquired 100 shares of Textiles Inc. stock for $50 a share, but the stock price since has dropped to $40 a share. If you sell the stock and buy it back within 30 days, you can’t deduct your $1,000 loss. (For simplicity, we will ignore transactional costs in this and other examples presented here.)
But you can sell the 100 shares of Textiles stock now and wait at least 31 days before buying it back. No matter how much the share price fluctuates in the future, you can still claim a $1,000 tax loss, because you didn’t acquire substantially identical securities within the prescribed 30-day period.
2. Doubling up. This strategy involves buying more shares of the same stock. Going back to our previous example, you might buy 100 additional shares of Textiles stock at $40 a share, and then wait at least 31 days to sell the original shares. If the sales price is still less than $50 a share, you have a deductible loss. Conversely, if the share price rebounds above $50, you will pocket a capital gain.
As long as the stock stays above the $40 mark, you lock in the gain when you sell the second block of shares. And if the price dips below $40 a share, you’ve managed to preserve your tax-deductible loss.
3. The rebound strategy. Alternatively, you might decide to sell the 100 shares of Textiles stock and buy additional shares when the price begins to bounce back. You can’t deduct the loss if the new purchase occurs within 30 days, but you can add the nondeductible loss to your basis in the replacement stock, which could reduce your capital gain.
Let’s say you sell the original shares of Textiles stock at $40 a share and buy another 100 shares—in less than 30 days—when the price moves up to $45 a share. Then you sell the second block of shares two months later at $60 a share. Your profit is $1,500, but you owe tax on only $500 because your basis in the new shares is $5,500 ($4,500 original basis plus $1,000 nondeductible loss).
4. Identifying shares. If you own multiple blocks of the same stock, then the “first-in, first-out” (FIFO) rule generally applies. The shares that you purchased first are considered to be the shares you sell first unless you specify other shares. But if you’re selling only some of your stock in a company, and if you bought some at a lower price, you could identify those cheaper shares as the ones you’re selling. If that means you’re actually realizing a small profit, instead of a loss, the wash sale rule never comes into play. That could make sense if you have an existing loss to offset the gain, and it gives you the flexibility to buy more of the stock.
You might also employ more complex strategies, such as creating a “cashless collar” by purchasing a put option and selling a call option simultaneously. We can provide details about that and other ways to avoid the wash sale rule.