Weekend Tax Read:
Coming Clean on the Wash Sale Rule
By Tracy Byrnes
Staff Reporter
10/3/98 12:16 PM ET
The Tax Forum joins forces with the Options Forum this weekend to bring you a long-awaited primer on the wash sale rule. Next week we'll both return to our normal Q&A formats, so send your questions on to taxforum@thestreet.com or optionsforum@thestreet.com. Don't forget to include your full name.
What the Heck Is the Wash Sale Rule Anyway?
Our options guy Dan Colarusso says to think of a wash sale this way: You're at the racetrack and you win $500 on your favorite horse in the third race. You believe you're on a roll, so you bet again. But you lose it all in the eighth race. The day turns out to be a wash, and you go home financially unaffected. (Your emotional situation is an entirely different story.)
The wash sale rule applies this concept to securities. If you buy a stock, sell it at a loss and then buy it back, you're holding the same position in which you started. Only, you've generated a tax loss in the process. But the government doesn't think you should be able to deduct that loss on your tax return if you haven't really altered your position, says Robert Willens, CPA and managing director of Lehman Brothers. If it's not a true economic loss, you don't get the deduction, says Tom Ochsenschlager, tax partner at Grant Thornton in Washington, D.C.
Section 1091 of the tax code says that if you sell a security at a loss, you can't deduct the loss on your tax return if you acquired a "substantially identical" security 30 days before or after the sale. So if you buy a stock on Monday and sell it at a loss on Tuesday, the wash sale rule says you can't claim that loss if you buy back the same stock within 30 days, says Ted Tesser, tax securities specialist in Boca Raton.
You can't do anything with the loss until the 30-day period is up, even at year-end. If you sold something at a loss on Dec. 28, 1998, you now have a 30-day window that goes into January. You must wait until that period is over before you file your 1998 tax return in order to take the loss, notes Shapiro.
But there's still one way to claim a loss if you buy back a security before the 30-day holding period is up: You can add the loss to the basis of the repurchased security. Let's say you buy a share at $10, sell it at $8, and buy it back within 30 days at $9. You can add the original $2 loss to your new cost basis, which is now $11. If the stock rises and then you sell, let's say at $12, your taxable gain is only $1.
Dealers and traders take note: Rules are different for you. The wash sale rule doesn't apply to dealers. And if you're an individual who elects trader status -- meaning you make your living by sitting in your office trading securities -- and you mark-to-market your trades (that is, value your portfolio at year-end as if you were selling it), you're excused from the rule. But dealers and traders who trade in their personal portfolios should read on.
What Does 'Substantially Identical' Mean?
Unfortunately, the tax code doesn't really offer up a good definition, so "it's kind of in the eye of the beholder," says Willens.
For you jargon lovers, there is a "substantially identical" test outlined in Taxes and Investing Guide, a booklet prepared by Richard Shapiro, an Ernst & Young securities tax partner (email his home at Richard.Shapiro@ey.com for a free copy.) But rather than slog through that jargon, we thought it'd be easier to give you examples of substantially identical securities in each of the sections below.
Stocks
Shares of the same stock in the same company are, obviously, substantially identical (though preferred stock is not substantially identical to common stock). Beyond that, the best way to illustrate the "substantially identical" rule is to go directly to some strategies for avoiding the wash sale rule:
Buy stock in a similar company.
The stock of one company is generally not substantially identical to the stock of another company in the same industry. Let's say you bought Talbots (TLB:NYSE - news) July 1, sold it Sept. 30 and took a 26.1% loss, then bought AnnTaylor (ANN:NYSE - news) on Oct. 1. That'll still give you exposure to women's apparel and generally get you back into the same position (actually, a better position, since ANN is up 8.2% since July 1), but it won't come under the wash sale rule.
Trade a sinking company for its merger partner.
If your favorite stock is in the process of a merger but has recently tanked, here's a way to stay in your stock but still take the loss. Let's say you're long the buyer in the merger and the stock is down a lot, but you still like the company. Sell it and buy stock in the target company. The rules say the stocks of two merger partners are not substantially identical as long as there's a contingency that still has to be satisfied before the merger goes through, says Willens. The yardstick here: Any trades made prior to shareholders' approval of the merger should be safe. "In a small way, you are doing merger arbitrage, but it's a great way to stay in the stock and cash in on a tax loss," he says.
Options
The IRS has "never to this day actually opined on when one option is substantially identical to another," notes Willens. So we must go with conventional wisdom. That said, as long as you vary the expiration date, you're okay. To be even safer, buy options with different strike and expiration dates.
For tax purposes, convertible preferreds and debentures are considered options. Even if the convertible is way out of the money, it doesn't matter. And even if you can't convert for five years, the passage of time doesn't detract from the rule, notes Willens. You can't sell the stock and buy a convertible within 30 days before or after the sale.
Some Strategies:
You can't go from the stock to the option but you can go from the option to the stock.
If you sell the stock, you can't buy the option even if the option is out of the money. The statute says that the wash sale will kick in if you "either buy a substantially identical security or enter into an option to buy a substantially identical security."
But let's say you're long an option, and you're losing your shirt on it. You can sell the option, buy back the underlying stock and, Voila!, no wash sale. Why? The option and the stock are not substantially identical, according to a 1958 IRS ruling.
Here's another tip. If you sell the stock at loss, you can't buy a call option within the 61-day period (30 days before the day of the sale and 30 days after), right? But you can sell a put option, as long as the put option is not deep in the money. So a put option with a strike price that's no more than one strike below will probably suffice, though that's not actually written in the statutes, says Willens. But this is a great trade because in either case you walk away still owning the stock.
Mutual Funds
"It's pretty difficult to flunk the wash sale test with mutual funds," notes Willens. Unless you buy back the same shares in the fund you just sold, it's almost impossible for one fund to be substantially identical to another. "I generally can't envision a situation that would evoke the rules with another fund," says Willens. "You are effectively immune."
Some Strategies:
Sell shares to generate a loss, then buy shares in a similar fund.
For example, sell your shares in Fidelity Growth & Income and buy Dreyfus Growth & Income instead, says Ochsenschlager.
But beware: If you plan to sell some shares, make sure you put a hold on any reinvested dividends or capital gains. They'll count as an acquisition, says Willens. So if you sell 100 shares today at a loss, but your dividends are reinvested next week, the amount of loss equal to the reinvestment will be disallowed by the wash sale rule.
Bonds
The code is better at defining "substantially identical" for bonds. Two securities aren't substantially identical if they are different in any of three material features: issuer, coupon or maturity. That makes things easy. You can sell a bond and buy another from the same municipality and avoid the wash sale rule as long as the bonds have a different coupon or maturity date.
Some strategies:
Try a "bond swap" at year-end.
Find some bonds in your portfolio that have generated losses and sell them. Then you can buy similar bonds and still have a decent tax loss, says Ochsenschlager.
IRAs and 401(k)s
Remember, if you trade in your IRA, 401(k) or any other tax-deferred account, you don't have to worry about the wash sale. And in most circumstances, you can sell a stock in your taxable account and buy it back in your tax-deferred account without the wash sale rearing its nasty head.
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TSC Tax Forum aims to provide general tax information. It cannot and does not attempt to provide individual tax advice. All readers are urged to consult with an accountant as needed about their individual circumstances. |
