Wash Sales

In what is referred to as a wash sale, you sell or dispose of stock or other securities, including options, at a loss, and within 30 days either before or after the date of the sale or disposal you directly or indirectly buy substantially identical securities or acquire them in a taxable trade, or you enter into a contract or purchase an option to acquire substantially identical securities.  A transaction could also be a wash sale if your spouse or a corporation you own acquires substantially identical securities within 30 days.

Losses on Wash Sales

Losses from wash sales are not deductible for tax purposes, unless you are a dealer in stock or securities and the loss was incurred in the normal course of your business.  Otherwise, the disallowed loss is added to the basis of the substantially identical stock or securities you purchase or acquire.  In this sense, the loss is postponed until you sell or otherwise dispose of the new securities you acquire.  The holding period for the new securities begins on the same date as the holding period for the securities you sold.

What Are Substantially Identical Securities?

What are considered substantially identical securities depends on the circumstances.  Normally, securities of different corporations are not considered substantially identical, although they could be in the case of a corporate reorganization.

Bonds or preferred stock in a corporation are generally not considered to be substantially identical to common stock of the same corporation.  But preferred stock that is convertible into common stock may be considered substantially identical to the common stock if it has the same voting rights, is subject to the same restrictions on dividends, it trades at prices that are not significantly different from the common stock prices taking into account the conversion ratio, and are not restricted as to their convertibility.

Matching Securities Bought and Sold

If the number of substantially identical securities you purchase 30 days before or after the sale is more or less than the number of securities you sold, you must match the securities bought with an equal number of shares sold, in the order you bought them.  These matched securities are the ones that are subject to the wash sale rules.  You cannot deduct a loss on the securities sold in the wash sale that are matched with substantially identical securities acquired 30 days before or after that date.  But you can deduct the loss for the portion of the sale that corresponds to securities that were not matched.  And, the basis of substantially identical securities you purchased, that were not matched with the securities sold in the wash sale, will be proportionally increased for the amount of the loss you could not deduct.

For example:

1. You bought 100 shares of common stock A on September 18 at $40 a share, for a total of $4,000.
2. On November 10 you bought 50 shares of substantially identical stock at $42 a share, for a total of $2,100.
3. On November 20 you bought 25 shares of substantially identical stock at $38 a share for a total of $950.
4. On December 1 you sold the 100 shares you bought in September for $30 a share, resulting in a loss of $1,000. 

• Because you bought 75 shares of substantially identical stock within 30 days before the date of the sale, you cannot deduct the loss on those shares ($10 a share loss x 75 shares = $750).  You can deduct the $250 loss on the other 25 shares.
• The basis of the 50 shares you bought on November 10 is increased by two/thirds (50/75)  of the disallowed loss ($750 x 2/3  = $500), so the basis of those shares would be $2,600 ($2,100 + $500), or $52 per share.
• The basis of the 25 shares you bought on November 20 is increased by one/third (25/75) of the disallowed loss ($750 x 1/3 = $250), so the basis of those shares would be $1,200 ($950 + $250), or $48 per share.

Losses and Gains on the Same Day

Losses from a wash sale of a block of securities cannot be used to offset gains from the sale of other blocks of substantially identical securities on the same day.

For example:

1. You buy three blocks of 100 shares each at different times of the year.  You paid $140 per share for the first block, $120 for the second block, and $110 for the third block.
2. On December 2 you sold 300 shares at $125 per share.
3. On December 30 you buy 250 identical shares of the stock,
4. You cannot deduct the loss of $1,500 on the sale of the first block ($12,500 - $14,000) because you acquired substantially identical shares within 30 days after the sale.
5. You cannot use the loss on the first block of stock to offset the gains on the second two blocks, because the sale of all the stock was made on the same day.

Wash Sales and Options and Futures Contracts

Losses from sales or trades of options to buy securities are also subject to the wash sale rules, just as the underlying securities would be.  But the wash sale rules do not apply to losses from sales or trades of commodity futures contracts and foreign currencies.

Losses from the sale, exchange or termination of a futures contract to sell are normally treated the same way as losses from the closing of a short sale.

Reporting Wash Sales

Even though a loss on a wash sale is not deductible, it must still be reported on Schedule D, Capital Gains and Losses, in either the short-term or long-term section, as applicable.  The amount of the loss should be shown as a negative number and on the line immediately below it, you should write “Wash Sale” in column (a) and show the amount of the loss in the amount column as a positive number, offsetting the negative amount of the loss.

Short Sales

A short sale is treated differently for tax purposes, in that a gain or loss may be recognized.  In a short sale, you enter into a contract to sell property that you borrow in order to deliver it to your buyer.  Later, you close the short sale and satisfy your obligation to your lender by buying substantially identical property and delivering it, or by delivering property you already held, but did not want to transfer at the time of the short sale.

On a short sale you do not realize any gain or loss until you deliver the property to close the sale.  If the property you deliver to close the sale is a capital asset (a stock held for investment purposes, for example), you will have a capital gain or loss on the short sale.  But you may have a constructive sale if you sell short an appreciated financial position and do not close the short sale.

Constructive Sales

A short sale may be deemed a constructive sale of an appreciated financial position.  In this case you must recognize the gain for tax purposes, as if the position had been disposed of at its fair market value on the date of the constructive sale.  Then, a new holding period starts on the date you recognize the gain on the constructive sale, and when you close the transaction, you would decrease the gain (or increase the loss) you realize by the amount of the gain you recognized on the constructive sale.

A short sale will be deemed a constructive sale if it involves the same property or property that is substantially identical to the property that has an appreciated financial position.  An appreciated financial position is an interest in a stock, a partnership interest, or a debt instrument (bond, for example), that would result in a gain if you disposed of it.

You will not have to report a constructive sale of an appreciated financial position if you closed the transaction within 30 days after the end of your tax year, you held the appreciated position during a 60-day period beginning on the date you closed the transaction, or your risk of loss was reduced at any time during this 60-day period.

For example, if you purchase 100 shares of stock in company A at $20 a share on June 1st and later sell short similar stock in company A on October 1st at $25 per share, and you do not close the short sale by January 30 of the following year, you would have a constructive sale, because if you had sold the stock you purchased on the date of the short sale, you would have had a gain of $5 per share.  You would report a short-term capital gain of $500 on your tax return.

Short or Long-Term Gain or Loss

Whether you have a short-term or long-term capital gain or loss will depend on your holding period.  Your holding period is normally the amount of time you actually hold the property that you eventually deliver to the lender in order to close the short sale.  For example, if you sell stock short that you do not own, but that you borrow from your broker, and then, over 12 months later, you purchase stock and turn it over to your broker to cover the short sale, you will have a short-term gain or loss on the short sale, because you effectively held the stock used to cover the short sale for less than a day.

If you acquired the substantially identical property after the date of the short sale but on or before the date you close the short sale, the gain or loss on the short sale is short-term.  The holding period for the substantially identical property begins on the earlier of the date of closing the short sale or the date on which you sell this property.

But, if you held substantially identical property on the date of the short sale, the gain will be short-term is you held the property for one year or less, and will be long-term if you held it for more than one year.  In this latter case, the gain or loss would be long-term even if you held the actual property used to close the short sale for one year or less.  What makes it long-term is the fact that you held substantially identical property for more than one year.