It is well known that taxes on capital gains dramatically dampen the returns on investments over the long run. It seems to reason that the majority of investors would want to reduce their tax liability. When investors sell assets at a lower price than what they paid, they can book a loss on their capital gains tax return. On the other hand, the IRS follows extremely certain guidelines regarding capital losses. You may protect yourself from unintentionally breaking the law by familiarizing yourself with the wash sale rule and gaining a full comprehension of its implications.

In layman's terms, the wash sale rule states that an investor is not eligible to claim a capital loss for taxation if they repurchase the stock or asset within 30 calendar days after selling it. To be more specific, the Internal Revenue Service (IRS) considers a transaction to be a wash sale if the investor engages in any of the following activities within 30 days before or after a sale:

• Buys the same investment as before
• Buys an investment that is quite comparable to the previous one
• Signs an agreement to purchase an investment that is comparable to the previous one
• Acquires the same stock for an individual retirement account (IRA) or a Roth IRA

Example

Imagine that you are an investor who made the terrible decision to buy Lucent Technologies stock while it was going for more than $70 per share. In the years that followed, before the company was swallowed up in a series of mergers and acquisitions, the investor saw the share price plummet to $1 due to accounting scandals, financial difficulties, and sales meltdowns.

Our investor, ever the entrepreneurial baron, recognizes that by selling their shares, they would be able to record a capital loss and reduce the tax they are required to pay. What's the issue? They are under the impression that Lucent, or the company that will eventually hold it, would emerge from the ashes and regain some of the market value that it had previously had.

Our investor has a sudden inspiration for a fantastic plan. They give their broker the direction to sell their shares in the telecom equipment provider during the final week of December, so locking in the capital loss. After waiting another three weeks, during first part of January, they request brokers to repurchase that shares of Lucent. They were able to lock in the capital loss while continuing to hold onto the shares; therefore, all is OK in the world. Doesn't it seem like a brilliant idea?

The IRS Is One Step Ahead

You should note that according to the wash sale rule, an investor is not permitted to claim capital loss if repurchases investment within the preceding thirty days. To put it another way, the investor will not be able to deduct the loss from their investment portfolio until they wait until the thirty-day period has passed.

To add insult to injury, Lucent may run up while waiting on the sidelines, increasing the purchase price. During this period, the investor will have already made two commission payments.

The Wash Sale Penalty

What are the repercussions for an investor if the IRS determines that they have broken the wash sale rule? The immediate consequence is that they won't be able to deduct the loss from their taxable income by using it on their tax return for that year.

On the other hand, they will be entitled to deduct the loss from the cost basis of the investment that they repurchased. The holding duration of the original investment may also be added to the holding period of the replacement investment if the investor so chooses. Because of this, they may be able to claim higher losses in the future or become eligible for a reduced rate of tax on capital gains.

How to Get Around the Rule

Would it not have been possible for the investor to wait until the wash sale period was through before repurchasing the shares? The answer is yes. This strategy, as was previously indicated, is fraught with several difficulties. In addition to the double fees, there is also a real possibility that Lucent will go up in the near future, forcing the investor to buy the stock at a higher price, which may be a substantial amount more than they had originally anticipated.

The lesson? You should only sell if you are willing to accept the possibility that you won't be able to buy the shares at the same or a lower price in the future. Nothing is preventing you from doing this if you can accept the reality of this potential.