What is a Wash Sale?
A wash sale is an illegal trading practice used by investors to circumvent the U.S. law which prohibits investors from claiming an investment loss on their taxes if they had bought a similar security within 30 days of the sale. It is seen as an attempt to artificially lower the cost basis of a position. In other words, a wash sale occurs when an individual or an entity sells a security at a loss, then purchases the same, or ‘substantially identical’ security within a 30-day period before or after the sale. The IRS, or Internal Revenue Service, then prohibits the investor from claiming the investment loss on their income tax return.

The Consequences
It is important for investors to be aware of the ramifications of engaging in wash sale transactions. In addition to being illegal, it can have significant tax consequences. The IRS automatically disallows the loss from the sale, but also applies the disallowed loss to the cost basis of the repurchased security. This reduces or eliminates the investor’s potential gain on the repurchased stock. Furthermore, investors who engage in wash sales must also pay a wash sale violation penalty. This penalty is equal to the amount of the disallowed loss generated by the wash sale.

Avoiding a Wash Sale
In order to avoid being caught in the potential tax implications of a wash sale transaction, it is important for investors to be familiar with how the IRS defines ‘substantially identical’ securities. The IRS views stocks, bonds, options and rights to acquire identical securities as all being substantially identical. It is also important for investors to be aware of their own financial activities and to be vigilant in avoiding trades that could be classified as a wash sale.

Investors should also be aware that if they are managing multiple accounts, such as their own personal accounts and an IRA or 401(k) account, they could be engaging in a wash sale without realizing it. This could occur when securities are sold from one account and then repurchased in another. It is important to take this into account when managing multiple accounts and to keep detailed records of all transactions. Finally, investors should be aware that wash sale rules also apply to security sales within a tax-advantaged retirement account.