How to Master Tax Loss Harvesting and the Wash Sale Rule?
Tax loss harvesting is often associated with year-end strategies, but it’s not limited to that timeframe— it’s a versatile tactic usable whenever necessary.
Consider a scenario: if you’ve employed various strategies delaying actions and now require substantial losses to balance gains in 2024, planning for that outcome is feasible now.
In the realm of taxable brokerage accounts, encountering an unsuccessful investment might seem bleak. However, selling the underperforming security presents an opportunity to harvest a tax-saving capital loss. But, beware! The dreaded wash sale rule could jeopardize this deduction.1
The objective of offsetting gains by tax loss harvesting prompts a deeper understanding of:
- How the wash sale rule operates,
- Strategies to outmaneuver it,
- Vague positions taken by the IRS on this matter, and
- Whether the rule extends to cryptocurrency losses.
- Understanding these aspects is crucial for strategic financial planning.
The Functionality of the Wash Sale Rule
For federal income tax considerations, should you sell stocks or mutual fund shares at a loss and subsequently acquire essentially identical securities within 61 days (30 days prior and 30 days after the sale), the incurred loss becomes ineligible for deduction.
For federal income tax considerations, should you sell stocks or mutual fund shares at a loss and subsequently acquire essentially identical securities within 61 days (30 days prior and 30 days after the sale), the incurred loss becomes ineligible for deduction.
However, a disallowed wash sale loss doesn’t vanish entirely.
Rather, the standard practice involves adding the disallowed loss to the tax basis of the substantially identical securities responsible for triggering the wash sale rule.2 Subsequently, when these securities are sold at a later date, this adjusted basis either decreases the tax gain or amplifies the tax loss.
Understanding this process is crucial for effective tax planning strategies.
Illustration 1: You procured 2,000 Chip Max shares on July 5, 2023, at $50,000 through your taxable brokerage firm account. Subsequently, the share value experiences a significant decline.
You aimed to secure a perceived tax-saving capital loss of $20,000 by divesting from the shares on December 15, 2023, selling them for $30,000 (calculating the loss as $50,000 basis minus $30,000 sales proceeds, equaling a $20,000 loss).
The intention was to utilize this $20,000 loss to offset an equivalent amount of 2023 capital gains from your successful stock market endeavors. After successfully securing what seemed to be a tax-saving loss, you proceeded to repurchase 2,000 Chip Max shares on December 22, 2023, for $31,000, driven by your preference for the stock.
Regrettably, the wash sale rule intervened, invalidating the anticipated $20,000 capital loss. Consequently, the disallowed loss elevated the tax basis of the essentially identical securities—namely, the Chip Max shares acquired on December 22, 2023—to $51,000 ($31,000 cost + $20,000 disallowed wash sale loss).
Two Strategies to Circumvent the Wash Sale Regulation
Bypassing the wash sale rule becomes a concern when aiming to sell a security to secure a tax-saving capital loss, yet desiring to retain ownership due to anticipated appreciation above the present value.
A method to bypass the wash sale rule involves utilizing the “double up” strategy: Acquiring an equal number of shares in the stock intended for sale at a loss, followed by waiting for 31 days before selling the initial batch.
Ultimately, this tactic secures a tax-saving loss sale while maintaining the original share count, allowing you to potentially benefit from anticipated appreciation.
Illustration 2: Facing a 2024 capital gain issue, you aim to secure a tax-saving loss on the existing 2,000 Big Pharma shares without relinquishing ownership. To achieve this, you purchase an additional 2,000 Big Pharma shares on December 21. Subsequently, selling the initial 2,000 shares after January 21, 2024, enables you to attain the desired tax-saving loss while steering clear of a wash sale scenario.
Below, Example 3 might present a more cost-effective approach toward accomplishing the same tax-saving objective. Consider acquiring a reasonably priced call option for the stock intended for the 2024 tax loss. Subsequently, wait beyond 30 days before selling the stock.
Illustration 3: Currently holding 2,000 Dandy Candy shares, your intention is to create a 2024 capital loss without relinquishing ownership of the stock.
An alternative method involves purchasing a February 2024 call option for 2,000 Dandy Candy shares, which may entail a modest expense compared to the higher cost of buying 2,000 actual shares. If you acquire the call option for 2,000 shares on December 21, 2023, you retain the option to sell your existing 2,000 Dandy Candy shares after January 21, 2024, to generate your intended 2024 loss and circumvent a wash sale scenario.
Nevertheless, ensure a waiting period of at least 31 days before selling the Dandy Candy shares. This caution is crucial because both the call option and the stock are considered substantially identical securities as per the wash sale rule’s guidelines.
Is the Wash Sale Rule valid if a related party, like your IRA, buys similar securities?
Interesting inquiry. When you sell stock for a loss and your spouse procures identical stock within the restricted 61-day period, one might reasonably assume that the wash sale rule applies, especially if filing jointly, as you and your spouse are treated as a single taxpayer.
However, neither the Internal Revenue Code nor IRS regulations explicitly address this scenario. IRS Publication 550 mentions the wash sale rule if your spouse obtains substantially identical securities within the 61-day period but doesn’t cover situations where separate returns are filed. This gap in coverage persists in the tax guidelines.3
Furthermore, the wash sale rule also extends to situations where your controlled corporation acquires substantially identical securities within the proscribed 61-day period. This aligns with a 1935 court decision, predating the current wash sale rule, favoring an anti-taxpayer stance.4
What about utilizing tax-favored retirement accounts like IRAs or 401(k)s to purchase substantially identical securities? IRS Revenue Ruling 2008-5 stipulates that such acquisitions within the restricted 61-day period trigger the wash sale rule.5 Moreover, the ruling indicates that you cannot increase your IRA’s basis by the disallowed loss amount, effectively nullifying the loss, per the IRS.
These interpretations stem from a 1933 court decision involving substantially identical securities acquired by a taxable trust controlled by the taxpayer.6 Notably, Revenue Ruling 2008-5 draws attention to the difference between a tax-exempt IRA trust and a taxable trust, though it appears to overlook this distinction.
In essence, IRS regulations established since 1956 don’t specifically cover the various “related party” scenarios mentioned above.7 Consequently, these IRS stances should be taken with a degree of skepticism.
It’s prudent to seek advice from a tax professional if you encounter situations where the application of the wash sale rule is ambiguous.
Current Exclusion: Cryptocurrency Losses Spared from Wash Sale Rule Impact
The current IRS classification of cryptocurrencies as “property” rather than securities8 implies that the wash sale rule doesn’t come into play if you dispose of a cryptocurrency asset at a loss and subsequently acquire the same cryptocurrency shortly before or after the sale.
In such instances, you’ll incur a typical short-term or long-term capital loss, contingent on your holding duration, without concerns about the wash sale rule.
This favorable treatment aligns with the traditional approach to handling losses related to foreign currencies.9
Potential changes in subjecting cryptocurrency losses to the wash sale rule might require congressional action. Stay informed of any forthcoming developments in this area.
Illustration 4: You initially purchased a cryptocurrency at a high price and later sold it at a significant loss of $100,000.
During the same period, you earned more than $100,000 in profits from stocks within your taxable brokerage account.
The silver lining? You’re able to offset the entire $100,000 from your stock gains using the loss incurred from the unfortunate cryptocurrency investment, even if you reinvest in the same cryptocurrency shortly after selling it.
This flexibility stems from the current exemption of cryptocurrency losses from the wash sale rule.
Caution: Selling crypto-related securities like Coinbase stock (Nasdaq: COIN) is subject to the wash sale rule. This rule pertains to losses from assets categorized as securities for federal income tax purposes. Stocks like Coinbase fall under the category of securities, distinct from cryptocurrencies, which are presently not classified as securities.
KEY TAKEAWAYS
Capital loss harvesting remains a reliable tax planning approach that you can employ whenever a loss-harvesting opportunity arises. However, it’s crucial to consistently navigate and overcome the wash sale rule.
In this piece, you’ve:
- Explored the mechanics of the wash sale rule
- Discovered various methods to counteract it
- Acknowledged debatable stances taken by the IRS
- Understood that cryptocurrency losses are exempt from the wash sale rule.
Capital loss harvesting remains a reliable tax planning approach that you can employ whenever a loss-harvesting opportunity arises. However, it’s crucial to consistently navigate and overcome the wash sale rule.
Get ahead with expert tax guidance! Call 832-303-3995 or book your appointment today.
- IRC Section 1091.
- Reg. Section 1.1091-2.
- IRS Pub. 550, Investment Income and Expenses (2022), dated Mar. 16, 2023.
- Sydney M. Shoenberg, 16 AFTR 95, 8th Cir. (1935).
- Rev. Rul. 2008-5.
- Security First National Bank of Los Angeles, 28 BTA 289 (1933).
- Reg. Sections 1.1091-1; 1.1091-2.
- Notice 2014-21.
- Rev. Rul. 74-218.