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Lane Keeter, CPA

Partner: Tax Consulting, Estate Planning, and Heber Springs Managing Partner

Harvesting Tax Losses on Securities & the Wash Sale Rules – Things to Know

As the stock markets declined throughout 2022, many investors sought safety by selling stock and other securities and moving to less volatile investments or even cash. Such sales often generated realized taxable capital gains, as investors cashed in on previous appreciation.

As we approach the end of the year, and facing the prospect of having to pay income tax on these gains, I had a discussion with a financial advisor recently about the advisability of looking for investments in a loss position that could be sold, thus "harvesting" tax losses that would offset at least in part the gains generated, a typical tax planning strategy. Part of the discussion centered around the "wash sale" rules as they relate to this strategy, which got my creative juices flowing (such as they are), and I realized this is a timely topic for this column.

A wash sale, generally, is where stocks are sold at a loss but then within 30 days are purchased again, so that in effect the portfolio position hasn't changed. When this occurs, the wash sale rules kick in, the effect of which is to prevent the deduction of the capital loss in the current year. Needless to say, this can torpedo your tax strategy. 

To that end, if you find yourself in the position where harvesting tax losses would benefit your tax situation, here are some important bits of information about wash sales that you need to know before doing so.

The first thing to know is the time window that could trigger the wash sale rules. As mentioned above the number 30 is important. However, it isn't simply that you can't reacquire the stock within 30 days after selling it. The period triggering the rules is actually both the 30 days before AND the 30 days after the sale; in reality a 61-day period. Acquisition of the replacement stock anytime within this 61-day period will cause the wash sale rules to apply. Also, to clarify, we're talking about calendar days, not business days.

Another key concept is that the rules are triggered by buying "substantially identical securities". Securities that meet this definition are not recognized as different enough to be considered separate investments. Substantially identical securities can include both new and old securities issued by a corporation that has undergone reorganization, or convertible securities and common stock of the same corporation. The IRS says that securities usually fall into this category if the market and conversion prices are the same, and are therefore not allowed to be counted in tax swap or other tax-loss harvesting strategies.

That said, if it makes investment sense to you, there is nothing that prevents you from buying the stock of another company in the same industry, or investing in a mutual fund or ETF that tracks said industry. Those transactions would not cause a wash sale.

Also, you won't be able to do an end around the wash sale rules by acquiring the replacement securities in an IRA or 401(k) account, or by acquiring them in another taxable account held elsewhere. While the wash sale rules don't apply when the original sale of the security takes place in an IRA or 401(k) (since no tax loss is being harvested), you cannot harvest the loss from a taxable account and then re-buy the stock in the IRA/4010(k) without triggering the wash sale rules. Further, if you do this anyway, the tax loss you took is lost forever according to the IRS. 

The wash sale rules can also come into play when buying stock via employee stock option exercises or employee stock purchase plans. Special rules beyond the scope of this article also apply to incentive stock options, so be sure to get professional advice before treading into those waters.

Finally, and on a positive note, when the wash sale rules do kick in to disallow a tax loss, the loss isn't gone forever, it's simply deferred (with the exception of the special rule mentioned above regarding IRA/401(k) reinvestments). The amount of loss you recognize but cannot deduct immediately is added to the replacement security's basis. This way, when you ultimately do dispose of it for good, you are able to deduct the loss at that time against the security's sale price. 

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