what is a wash sale 
a wash sale is a transaction in which an investor sells or trades a security at a loss and purchases a substantially similar one 30 days before or 30 days after the sale 1 this is a rule enacted by the internal revenue service irs to prevent investors from using capital losses to their advantage at tax time the wash sale rule applies to stocks contracts options and all other types of securities and trading understanding a wash salemany countries tax laws allow investors to claim a specific amount of capital losses on their taxes as an income reduction in the u s you can claim up to 3 000 or your total net loss whichever is less if you have more than 3 000 in capital losses you can carry the additional loss forward into the following years 2the ability to carryover losses led to investors inventing a loophole where they would plan to sell a losing security and buy it again within a short period this allowed them to claim a capital loss and use that loss to mitigate tax liabilities to prevent the abuse of this incentive the internal revenue service irs instituted the wash sale rule in the u s in the u k the practice is known as bed and breakfasting and the tax rules in the u k have an implementation similar to the wash sale rule the law states that if an investor buys a security within 30 days before or after selling it any losses made from that sale cannot be counted against reported income this effectively removes the incentive to do a short term wash sale generally a wash sale has three parts day traders especially pattern day traders those that execute more than four day trades over a five day period in a margin account may encounter wash sales regularly the wash sale rule still applies to these traders the tax implications for day traders are complex so it s best to consult a tax professional if you re day trading wash sale exampleassume an investor has a 15 000 capital gain from the sale of abc stock they fall in the highest tax bracket and must pay a 20 capital gains tax of 3 000 but let s say they sold xyz security for a loss of 7 000 the net capital gain for tax purposes would be 15 000 7 000 8 000 which means they ll have to pay only 1 600 in capital gains tax notice how the realized loss on xyz reduces the gain on abc reducing the investor s tax bill however if the investor repurchases xyz stock or a stock substantially identical to xyz within 30 days of the sale the above transaction is counted as a wash sale and the loss is not allowed to offset any gains the irs does not ordinarily consider bonds and preferred stock of an issuing company to be substantially identical to the company s common stock however there may be circumstances where preferred stock for example may be considered substantially identical to the common stock this would be the case if the preferred stock is convertible into common stock without any restriction has the same voting rights as the common stock and trades at a price close to the conversion ratio per revenue ruling 2008 5 ira transactions can also trigger the wash sale rule if shares are sold in a non retirement account and substantially identical shares are purchased in an ira within 30 days the investor cannot claim tax losses for the sale nor is the basis in the individual s ira increased 3reporting a wash sale lossthe good news is that any loss realized on a wash sale is not entirely lost instead the loss can be applied to the cost basis of the most recently purchased substantially identical security not only does this addition increase the cost basis of the purchased securities but it also reduces the size of any future taxable gains as a result thus the investor still receives credit for those losses but at a later time also the holding period of the wash sale securities is added to the holding period of the repurchased securities which increases an investor s odds of qualifying for the 15 favorable tax rate on long term capital gains tax loss harvesting can inadvertently lead to wash sales if not carefully managed tax loss harvesting is the strategy of selling securities at a loss to offset a capital gains tax liability elsewhere and then buying back a replacement security to maintain the existing portfolio s overall composition the objective is to lower your overall tax bill by realizing those losses however if you re not careful about how you replace the securities you ve sold you can trigger the wash sale rule to avoid this investors often look for alternative investments that are similar but not substantially identical 