You generally think of tax loss harvesting as a year-end strategy. And it truly is a good one.
But it’s also a “whenever you need it” strategy.
For example, say you used a lot of “kick the can down the road” strategies this year and need a big loss to offset gains in 2024. You can set up that accomplishment now.
When you make what turns out to be an ill-fated investment in a taxable brokerage firm account, the good news is that you can harvest a tax-saving capital loss by selling the loser security. Right? Well, maybe not.
You could destroy that loss deduction by running a foul of the dreaded wash sale rule.
Let’s say you have harvesting tax losses to offset gains on your mind. Here’s the current story on
- how the wash sale rule works,
- a couple of ways to defeat it,
- some questionable IRS positions on the subject, and
- whether the rule applies to cryptocurrency losses.
How the Wash Sale Rule Works
For federal income tax purposes, a loss from selling stock or mutual fund shares is disallowed if, within the 61 days beginning 30 days before the date of the loss sale and ending 30 days after that date, you buy substantially identical securities.1
The theory behind the wash sale rule is that the loss from selling a security and acquiring substantially identical securities within the 61-day window adds up to an economic “wash.” Therefore, you’re not entitled to claim a tax loss.
Fortunately, when you have a disallowed wash sale loss, the loss doesn’t vaporize.
Instead, the general rule is that the disallowed loss is added to the tax basis of the substantially identical securities that triggered the wash sale rule.2 When you eventually sell the substantially identical securities, the additional basis reduces your tax gain or increases your tax loss.
Example 1. You bought 2,000 Chip Max shares on July 5, 2023, for $50,000 using your taxable brokerage firm account. Thereafter, the share value plummets.
You harvest what you think is a tax-saving $20,000 capital loss by bailing out of the shares on December 15, 2023, for $30,000 ($50,000 basis – $30,000 sales proceeds = $20,000 loss).
You intend to use the $20,000 loss to shelter an equal amount of 2023 capital gains from your successful stock market bets. Having bagged the tax-saving loss(or so you thought), you then reacquire 2,000 Chip Max shares on December 22, 2023, for $31,000, because you like the stock.
Sadly, the wash sale rule disallows your expected $20,000 capital loss. The disallowed loss increases the tax basis of the substantially identical securities—the Chip Max shares you acquire on December 22, 2023—to $51,000 ($ 31,000 cost + $20,000 disallowed wash sale loss).
Two Ways to Defeat the Wash Sale Rule
Defeating the wash sale rule is only an issue when you want to sell a security to harvest a tax-saving capital loss but still want to own the security because you expect it to appreciate above the current price.
One way to defeat the wash sale rule is with the “double up” strategy: You buy the same number of shares in the stock you want to sell for a loss. Then you wait 31 days to sell the original batch of shares. When all is said and done, you’ve made a tax-saving loss sale, but you still own the same number of shares as before and can therefore still benefit from the anticipated appreciation.
Example 2. You have a 2024 capital gain problem. You want to sell the 2,000 BigPharma shares that you currently own for a 2024 tax-saving loss. But you don’t want to give up on the stock. So, on December 21, you buy 2,000 more BigPharma shares.
Now, you can sell the original batch of 2,000 shares for a tax-saving loss any time after January 21, 2024, and avoid a wash sale.
Example 3 (below) may be a much-less-expensive way to achieve essentially the same tax-saving goal. Try to buy a relatively inexpensive call option on the stock you want to sell for the 2024 tax loss. Then wait more than 30 days to sell the stock.
Example 3. You currently own 2,000 Dandy Candy shares that you want to sell to create a 2024 capital loss. But you don’t want to give up on the stock.
It might only cost a modest amount to buy a February 2024 call option for 2,000 Dandy Candy shares, while buying 2,000 actual shares would cost much more.
Say you buy a call option for 2,000 shares on December 21, 2023. You can sell your 2,000 Dandy Candy shares that you currently own anytime after January 21, 2024, to harvest your 2024 loss and avoid a wash sale.
But be sure to wait at least 31 days before selling the Dandy Candy shares, because the call option and the stock are considered substantially identical securities for purposes of the wash sale rule.
Does the Wash Sale Rule Apply When a Related Party—Including Your IRA—Acquires Substantially Identical Securities?
Good question. If you sell stock for a loss and your spouse buys identical stock within the forbidden 61-day period, it does not seem unreasonable to believe that the wash sale rule applies if you file jointly with your spouse—because you and your spouse are treated as one taxpayer.
But nothing in our beloved Internal Revenue Code or IRS regulations addresses this situation. IRS Publication550 simply says that the wash sale rule applies if your spouse acquires substantial identical securities within the 61-day period—without mentioning the situation where you and your spouse file separate returns.3 Once again, this situation is not addressed in the Internal Revenue Code or IRS regulations.
According to Publication 550, the wash sale rule also applies when your controlled corporation acquires substantially identical securities within the forbidden 61-day period. The support for this anti-taxpayer notion is apparently a 1935 court decision that was decided long before the current wash sale rule existed.4
Finally, what happens if you use your tax-favored retirement account—IRA, 401(k), etc.—to buy substantially identical securities?
According to IRS Revenue Ruling 2008-5, having your traditional or Roth IRA buy substantially identical securities within the forbidden 61-day period triggers the wash sale rule.5 Even worse, Revenue Ruling 2008-5 says that you cannot increase the basis of your IRA by the amount of the disallowed loss. Therefore, according to the IRS, the disallowed loss simply goes up in smoke.
These anti-taxpayer epiphanies rely on a 1933 court decision where substantially identical securities were acquired by a taxable trust that was controlled by the taxpayer.6
Revenue Ruling 2008-5 notes that an IRA is a tax-exempt trust, whereas the trust in the 1933
Security First National Bank case was a taxable trust, and then ignores the distinction. It seems fair to observe that the distinction between a taxable trust and a tax-exempt IRA trust is a pretty big one that should not be so carelessly dismissed.
Bottom line. IRS regulations dealing with the wash sale rule have been on the books since 1956, but they don’t address any of the aforementioned “related party” circumstances.7 Therefore, we think you can take the self-serving IRS positions above for what they are worth.
That said, consult with your tax pro if the issue of whether the wash sale issue applies comes up in any of the above-mentioned situations.
Cryptocurrency Losses Are Exempt from the Wash Sale Rule (for Now)
The IRS currently classifies cryptocurrencies as “property” rather than securities.8 That means the wash sale rule does not apply if you sell a cryptocurrency holding for a loss and acquire the same cryptocurrency shortly before or after the loss sale.
In this case, you just have a garden-variety short-term or long-term capital loss depending on your holding period. No wash sale rule worries.
This favorable federal income tax treatment is consistent with the long-standing treatment of foreign currency losses.9
It would probably take an act of Congress to make cryptocurrency losses subject to the wash sale rule, but that could happen. Stay tuned for possible developments.
Example 4. You bought a cryptocurrency holding high and sold it low for a $100,000 loss. During the year, you also rang up more than $100,000 in stock gains in your taxable brokerage firm account.
You can offset $100,000 of your stock gains with the loss from the ill-fated cryptocurrency investment even if you buy back into the same cryptocurrency shortly after the loss sale.
The reason: as things currently stand, cryptocurrency losses are exempt from the wash sale rule.
Warning. Losses from selling crypto-related securities, such as Coinbase stock (Nasdaq: COIN), fall under the wash sale rule because the rule applies to losses from assets classified as securities for federal income tax purposes. Stocks such as Coinbase are securities, while cryptocurrencies themselves are not currently classified as securities.
Harvesting capital losses is a tried-and-true tax planning strategy. And it’s a strategy you can use anytime the opportunity is there and you need to harvest a loss.
But always make sure you defeat the wash sale rule.
In this article, you
- saw how the wash sale rule works,
- learned a couple of ways to defeat it,
- noted some questionable IRS positions on the subject, and
- learned that the wash sale rule does not apply to cryptocurrency losses.
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