Wash sales

A wash sale occurs if an investor sells a security at a loss and repurchases it within 30 days of the original sale. This rule prevents investors from selling investments to lock in a deductible capital loss, only to repurchase it immediately or quickly after. For example:

January 20

Investor purchases 100 shares at $50

March 15

Investor sells 100 shares at $20
Realized loss of $30 per share ($3,000 overall)

March 16

Investor buys 100 shares at $20

Although the investor sold their shares at a loss, they repurchased the shares the next day. Nothing significant occurred except for the $3,000 realized loss, which is deductible. The IRS feels this encourages investors to sell securities at a loss and repurchase them to obtain tax benefits. To prevent it from commonly occurring, the wash sale rule was created and imposed on security transactions. The basics of the rule are:

Capital losses are disallowed if security is repurchased within 30 days of the sale
Disallowed loss is added to the cost basis of the new position

Let’s run through an example:

An investor purchases 100 shares of MNO Fund at $50 per share on February 10th. On April 20th, the shares are sold for $28 per share. On May 5th, the investor buys 100 shares of MNO Fund at $30.

In this example, the investor locks in a $22 per share loss on April 20th, resulting in an overall $2,200 deductible capital loss. 15 days later, the investment is repurchased for $30 per share. The $22 per share loss is disallowed and cannot be used for a tax deduction.

The loss doesn’t completely evaporate, though. The disallowed loss is added to the cost basis of the new position, which helps reduce potential taxes when the investment is sold again. Although 100 new shares were purchased at $30, the investor will reflect a cost basis of 100 shares at $52 per share ($30 + $22 disallowed loss). If the investor were to sell their shares at the $30, they would reflect a $22 per share loss ($30 sales proceeds vs. $52 cost basis). If the investor doesn’t repurchase the shares again within 30 days, they can keep the $22 per share loss.

The wash sale rule applies to repurchases of the same security, or even a similar security. The IRS refers to these as “substantially identical securities.” For stock, this includes:

Convertible securities
Rights*
Warrants*
Options

*Rights and warrants are derivative securities that provide the right to buy stock at a fixed price. Other than discussing their impact on wash sales, we do not expect you to encounter any Series 6 test questions on these securities. If you’re curious, you can review their characteristics on the Achievable Series 7 program.

If a security provides an easy way to obtain the stock (through converting or exercising), it’s considered the same as buying the actual stock. For bond wash sales, it’s a bit different. If an investor repurchases a bond within 30 days of selling a bond at a loss, they can avoid the wash sale rule if two of the following three items on the new bond are different:

Coupon
Maturity
Issuer

The 30-day wash sales period applies before and after the loss is realized. This prevents investors from “front-loading” shares. For example:

An investor purchases 100 shares of AXP Fund at $90 per share on August 20th. On October 1st, 100 more shares of AXP Fund are purchased at $76. The next day, the shares are sold for $73 per share.

Before selling their shares at a loss, the investor purchased an additional 100 shares. On October 2nd, they sell the original 100 shares (assuming FIFO; see below additional information on FIFO) for a $17 loss ($73 sales proceeds vs. $90 cost basis). Additional shares were purchased the previous day, within the 30-day wash sale period. Therefore, the $17 loss is disallowed and added to the cost basis of the current position. The investor now reflects a $93 per share cost basis ($76 cost basis + $17 disallowed loss). If they sell these shares later, they can keep any realized loss as long as they do not repurchase the shares again within 30 days of the sale.

Sidenote

Selling specific shares

When investors sell shares accumulated over several trades, deciding what shares to sell becomes an important objective. Let’s assume an investor purchases $10,000 of the fund over a 3-year period, all at different prices per share (known as dollar cost averaging, which we’ll discuss in the next chapter).

Year	Purchase amount	Price per share	Shares purchased
2020	$10,000	$20	500
2021	$10,000	$25	400
2022	$10,000	$16	625

Unless otherwise specified, shares are sold on a first-in, first-out (FIFO) basis as a default, meaning the oldest shares are sold first. Let’s assume the investor sells 800 of their 1,525 shares at $30 per share and uses this method. In this example, they would be selling:

500 shares purchased at $20/share
300 shares purchased at $25/share

Next, the investor can find their overall cost basis by adding up the numbers. They bought 500 shares for $10,000 in 2020 and 300 shares for $7,500 (300 shares x $25 per share) in 2021. The total cost of the 800 shares (500 + 300) was $17,500 ($10,000 + $7,500). This adds up to an average cost basis of:

800 shares purchased at $21.88 ($17,500 / 800 shares)

When the investor sells those shares at $30 per share, they lock in an overall $8.12 per share gain ($30.00 sales proceeds - $21.88 cost basis).

The investor could also opt to sell shares on a last-in, first-out (LIFO) basis, which would sell the newest shares first. Again, let’s assume the investor sells 800 shares at $30 per share and find the overall gain using this method:

625 shares purchased at $16/share
175 shares purchased at $25/share

Let’s find their average cost basis. They bought 625 shares for $10,000 in 2022 and 175 shares for $4,375 (175 shares x $25 per share) in 2021. The total cost of the 800 shares (625 + 175) was $14,375 ($10,000 + $4,375). This adds up to an average cost basis of:

800 shares purchased at $17.97 ($14,375 / 800 shares)

When the investor sells those shares at $30 per share, they lock in an overall $12.03 per share gain ($30.00 sales proceeds - $17.97 cost basis).

Last, the investor can also utilize a method called specific share identification, where the investor specifically identifies which shares to sell. To minimize taxes as much as possible, the investor will first sell the most expensive shares. Using this method, they’ll sell:

400 shares purchased at $25/share
400 shares purchased at $20/share

Let’s find their average cost basis. They bought 400 shares for $10,000 in 2021 and 400 shares for $8,000 (400 shares x $20 per share) in 2020. The total cost of the 800 shares (400 + 400) was $18,000 ($10,000 + $8,000). This adds up to an average cost basis of:

800 shares purchased at $22.50 ($18,000 / 800 shares)

When the investor sells those shares at $30 per share, they lock in an overall 7.50 per share gain ($30.00 sales proceeds - $22.50 cost basis). Let’s compare all of the numbers now:

Method	Gain per share
FIFO	$8.12
LIFO	$12.03
Specific share	$7.50

Of the three methods, specific share identification was the most tax efficient. Remember, the lower the reported gain, the less taxes the investor pays. Specific shares identification always allows investors to reduce their tax liability to the lowest possible level.

There is one additional method of determining what shares are sold, but it is only available to mutual funds (not stocks or other securities). Known as average cost, single category (ACSC), this method reflects a cost basis equal to the average of all shares purchased. Using the first table of this sidenote (above), the investor purchased 1,525 shares for a total of $30,000, resulting in an average cost of $19.67 ($30,000 / 1,525 shares).

Investors opting for ACSC are “locked in” after the first reported transaction. While investors are typically free to switch sales reporting methods (e.g. going from FIFO to LIFO), once ACSC is elected, it must be used until the position is completely liquidated.

Key points

Wash sales

Losses disallowed security is repurchased within 30 days of a sale
Disallowed loss added to cost basis of current position
Applies to stocks if purchasing substantially identical securities:
- Convertible securities
- Rights
- Warrants
- Options
Bonds avoid rule if the new bond has 2 of 3 items different:
- Coupon
- Maturity
- Issuer

Selling security shares or units

Investors can utilize FIFO, LIFO, or specific share identification
Specific share identification results in the lowest tax liability

Average cost, single category

Shares reflect the average cost for tax reporting
Only available to mutual funds
Investors “locked in” to this method once utilized