What it is:
A wash sale occurs when an investor sells a security at a loss but then purchases the same or a substantially similar security within 30 days of the sale.
How it works/Example:
Let's assume an investor owns 100 shares of XYZ Company and sells these shares on May 1 for a $1,000 loss. Then the investor purchases 100 new shares of XYZ Company on May 5 and sells those shares for a $2,000 gain.
In this situation, the investor might attempt to claim a tax deduction for the initial $1,000 loss. The deduction would offset some of the tax due on the subsequent $2,000 gain, meaning that the investor would pay less tax on the gain even though his position in the stock never materially changed. However, because the investor purchased the second set of shares within 30 days of the sale of the first set of shares, the IRS will tax the investor on the full $2,000 gain from the second transaction.
The IRS rules on wash sales apply to very similar securities, meaning that transactions involving options, warrants, certain types of preferred stock, and short sales on the security in question within the thirty-day period may count as wash sales. The rules also applies to a taxpayer's spouse, meaning that a loss-generating sale by one and subsequent purchase by the other may be considered a wash sale, as may agreements among friends to repurchase securities from each other when the wash sale period ends. Further, the IRS does not require that the same number of similar securities be traded in each part of the transaction to count as a wash sale.
When a wash sale does occur, the investor must add the loss to the basis of the most recently purchases substantially similar securities. This addition increases the cost basis of the purchased securities and 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.
The wash sale window spans 61 days: 30 days before the sale, the day of the sale, and 30 days after the sale.
Why it Matters:
Claiming tax deductions for losses resulting from wash sales is illegal. Although investment losses are generally tax deductible, selling securities at a loss in order to get a tax benefit and then buying the stock back right away allows tax evaders to create synthetic tax deductions without really changing their positions in a security. Thus, the Tax Reform Act of 1984 allows the IRS to prohibit taxpayers from deducting losses on the sale of an investment if the taxpayer purchases the same security 30 days before or after the sale. This is called the wash-sale rule.
The Commodity Exchange Act has similar prohibitions regarding wash sales, and wash sales also violate Section 9(a)(1)(A) and Rule 10b-5 of the Securities Exchange Act of 1934. The focus of these rules is on preventing conspiracies to artificially inflate a security's price by engaging in wash sales, which increase the perceived trading volume of a security and therefore induce legitimate trades by other investors.