Beware the wash sale rule

Tom McGraw, Head of Tax Advisory, Advice Lab
Adam Ludman, Tax Advisory, Advice Lab
Cheyenne Del Savio, Tax Advisory, Advice Lab
 

As the end of the year approaches, it is wise to consider how you might save on your tax bill using a strategy known as “tax-loss harvesting.”

This strategy—which can be particularly powerful when markets have been volatile—involves realizing capital losses with the intention of using them to offset your realized capital gains, thereby lowering your tax bill for the year.¹

There can be significant benefits to harvesting losses. But make sure you do not run afoul of the so-called “wash sale” rule, which can be complicated to navigate. Thus, be mindful of common pitfalls to avoid disrupting your careful planning.

What is the wash sale rule?

The wash sale rule prohibits taxpayers from claiming a loss on the sale or other disposition of a stock or securities if, within the 61-day period that begins 30 days before the sale (generally, the trade date) or other disposition, they:

• Acquire the same or “substantially identical” stock or securities; or
• Enter a contract to acquire stock or securities (e.g., call options)

The wash sale rule also applies to short sales.²

The wash sale rule exists to prevent taxpayers from taking losses (thus lowering their tax bill) when they are not economically out of a particular position for a sufficient period of time.

Consequences of running afoul of the wash sale rule can be significant:

• The loss from the sale of the original shares is disallowed
• The amount of the disallowed loss is added to the basis of the newly acquired shares, and realized only when the newly acquired position is sold
  
• Additionally, the taxpayer’s holding period on the original shares is added to the holding period of the newly acquired shares
  

To illustrate:

On June 1, 2023, Tom sold 100 shares of ABC stock for $100 a share, initially purchased for $110 each. He held the shares for more than one year (long-term). Thus, his capital loss was $1,000 (100 shares @ $10 per share). On June 10, 2023, Tom repurchased 100 shares of ABC stock for $105 a share. Since the wash sale rule applies:

• The $1,000 loss would be disallowed
• The $1,000 would be added to the cost basis of the new shares, and the new cost basis would be $115 per share ($105 per share + $10 per share disallowed loss)
• These newly purchased shares are considered to be held long-term because of the holding period of the original shares

When does the wash sale rule apply?

The wash sale rule applies to transactions in stock or securities, including debt securities, and contracts to acquire stocks or securities.

This includes, for example, warrants, convertible preferred stock and options contracts. It is not clear, however, whether the rule covers some common financial instruments, such as equity swaps. So, you must work closely with your tax advisor to confirm whether or not a particular transaction may give rise to a wash sale.

Another key determination is whether two securities are “substantially identical”; but, the wash sale rule uses this term without precisely defining it. Ultimately, a taxpayer must consider the economics of the two positions. (Again, with the assistance of your tax advisor.)

One widely cited case suggests a taxpayer should ask, generally, whether a knowledgeable investor, fully armed with all relevant facts, would discern a sufficiently material economic difference between two positions such that her decision making would prejudice her toward one position over the other.³

If the answer to this question is “no,” the two positions are likely substantially identical—and, therefore, the wash sale rule could apply, even though the pair of transactions involved two different securities.

Unfortunately, there is no bright line test and the determination of what is substantially identical requires an analysis of the specific facts and circumstances. For example, for two debt securities of the same issuer not to be considered identical, the securities’ other features (e.g., coupon, maturity, call features, degree of subordination, etc.) would have to be different enough that they created a difference in the economics of the two positions.

In applying the wash sale rule, you should also be aware of trading activity in your other accounts. The wash sale rule could apply to transactions in any account you (or related parties) have with another financial institution, including retirement accounts, accounts held by your disregarded entity (e.g., single member LLC) or grantor trust, or accounts held by your spouse.

Make sure to also watch out for vesting and the exercise of compensatory options or restricted stock grants and automatic dividend reinvestments, which qualify as the acquisition of stock for purposes of the wash sale rule.

What types of transactions could trigger the wash sale rule?

Always consult your tax advisor before you engage in transactions that might be considered a wash sale. However, it can be helpful to understand where the rule could apply.

Transactions that should trigger wash sales include, for example:

• Selling a position in one account and buying it back in another account with the same or another financial institution
• Selling a position in a taxable account and buying it back in your IRA (here, the loss would be lost completely, because the position in the IRA has no basis)
• Selling a position at a loss in your account, then your spouse buying it back in their account (even if your spouse files separately, the loss may be disallowed)
• Selling a position at a loss and buying it back in a disregarded entity you own (such as a single-member LLC) or a grantor trust (or vice versa)
• Selling a position at a loss and a partnership or corporation you control buying it back (or vice versa)
• Selling a position at a loss and acquiring a call option or writing a deep-in-the-money put option on the same position
• Selling a stock at a loss and acquiring new shares due to automatic dividend reinvestment
• Selling a stock at a loss within 30 days of a restricted stock/restricted stock units (RSUs) vesting or an exercise of compensatory options

Alternatively, if you want to hold the same stock or securities and do not want to be out of the market for an entire month, you can “double up” on your position. For example, buy the identical position at the current price, wait 30 days, then sell the original loss position and potentially recognize the loss this year. You will want to make sure you leave enough time to sell the original position before the end of the calendar year.

We can help

All of your tax moves should be thoroughly discussed with your tax advisors.

While J.P. Morgan does not provide legal or tax advice (and cannot opine on whether a particular transaction is a wash sale), your J.P. Morgan team can help you and your tax advisors assess potential tax-loss harvesting opportunities. You may also benefit from having a so-called “separate, tax-managed account”—i.e., one designed to continuously look for losses and harvest them when opportunities arise.

To learn more about our capabilities, please contact your J.P. Morgan team.

¹Please consult your tax advisor to see if tax-loss harvesting is available with your accounts, and how potential buybacks may be done successfully. Taxes should not be the only factor to drive an investment decision.

²U.S. Internal Revenue Code, Section 1091.

³Hanlin v. Commissioner, 108 F.2d 429 (3d Cir. 1939).

⁴The wash sale rule does not currently apply to direct investment in assets other than stock or securities, including commodities (such as allocated gold), currencies or digital assets (such as cryptocurrency). Recent proposals in Congress to expand the scope of assets subject to the wash sale rule beyond “securities” did not pass. So at this time, the wash sale rule still does not apply to certain assets that historically fall outside its scope.