What Is the Wash Sale Rule?

While investing is a great way to grow your money, it also comes with the risk of losing money. The silver lining of losing on an investment in a taxable account is getting a tax break on the loss through a strategy known as tax-loss harvesting. But there are some situations in which you could lose that tax break. A wash sale is one of them.

A wash sale is when you sell an investment at a loss and then repurchase it (or one just like it) within 30 days. The 30 days can be before or after the sale. While it’s OK to make a wash sale, claiming the loss on your taxes violates tax regulations.

The IRS has rules about wash sales to prevent you from claiming a loss on a security when you’re really ending up in the same position you were in prior to selling and rebuying. Here you’ll learn what you need to know about the wash sale rule and get tips to avoid losing out when deducting losses from your taxes.

What is the wash sale rule?

The wash sale rule is an IRS regulation that prevents you from taking a tax deduction on losses for securities that were sold and repurchased within 30 days. If you sold a stock at a loss but repurchased the same shares (or substantially identical shares) within 30 days before or after the sale, you are not able to claim the losses on your taxes. Instead, the amount of the loss is added to the cost basis of your new purchase.

How the wash sale rule works

If you sell an investment at a loss, the IRS allows you to offset other investment gains you may have. You can also deduct up to $3,000 in realized losses from your ordinary income on your taxes. So, if five years ago you bought 100 shares of a $50 stock and the value of each share declined to $30 today, your sale of the stock today would result in a $2,000 loss. You’d be able to offset a $2,000 investment gain or deduct $2,000 from your income, lowering the amount of tax you’d owe.¹

But let’s say that two weeks go by. You decide to keep your position in that stock, and you repurchase your 100 shares at $31 each. You can no longer use the $2,000 of losses from your previous sale as a tax deduction because the transactions are considered a wash sale.

Instead, your $2,000 in losses would be added to the cost basis of the stock you rebought—increasing your cost basis and reducing the amount of tax you may need to pay on future gains.

Transactions that may trigger wash sales

A wash sale applies to any accounts you and your spouse own. So if you sell stocks in one account, you cannot evade the wash sale rule by repurchasing with a spouse’s account. The wash sale rule would apply if:

• You sell stocks you own in one investment account and use another account to buy the same stocks within 30 days.

• You sell stocks in a taxable investment account and repurchase them with a retirement account (like an IRA or 401(k)) within 30 days.

• You sell stocks at a loss from an account in your name, and then your spouse purchases stocks with an account in their name within 30 days.

• You sell a stock that you own with a personal account and purchase it with another entity you own (like an LLC) within 30 days.

Remember, the 30 days can be before or after the sale.

What securities are covered by the wash sale rule?

The wash sale rule applies to most investment assets, including stocks, exchange-traded funds and mutual funds. However, depending on the type of investment, it may not always be clear what a substantially identical investment is (and unfortunately, while the IRS provides guidance on this topic, it doesn’t specifically define the term).

Especially with mutual funds and exchange-traded funds, the lines can get blurry. What makes a fund substantially identical may change depending on the type of fund, but you typically can’t sell one company’s index fund and buy shares in a different company’s index fund. An example would be selling one company’s fund that tracks the S&P 500 and buying a different company’s fund that also tracks the S&P 500. When it comes to stocks, you may not be able to buy the same stock back, but you can buy shares in another company that is similar in industry or size.

Understanding what a substantially identical investment is makes navigating wash sale rules challenging, so it’s best to consult with an investment advisor or tax professional before making transactions.

What are the tax implications of the wash sale rule?

There’s no actual penalty for a wash sale. You can sell and purchase a stock as many times as you’d like within any time frame.

But the wash sale rule becomes relevant when you’re looking to claim realized losses on your taxes. If you’ve sold and repurchased substantially identical assets within 30 days—to pursue a strategy such as tax-loss harvesting—then you’re no longer able to claim the realized losses on your income tax return. Instead, the amount of the loss is added to the cost basis of your new stock purchase.

Is it a wash sale if you sell at a profit?

A transaction is considered a wash sale only if the sale results in a loss. If you make a profit on a sale, the wash sale rule would not apply, as you will likely owe tax.

If you sell an asset at a profit, you’ll pay capital gains tax on your earnings. Then, if you decide you’d like to repurchase that stock, you can.

How do I avoid a wash sale?

Here are some actions you could take to avoid the wash sale rule without significantly harming your investment strategy:

Buy a similar investment

If you’re looking to quickly get your money back into the market, you could look for a similar company (but not substantially identical) in the same industry or “sector” as your previous investment. For example, you could buy into a utility stock using money from the sale of another utility stock. Or you could track the same index with a different (yet similar) fund. An example would be selling a passive index tracking ETF and then buying an active mutual fund that benchmarks to the same index.

Stick to your investment plan

During market downturns, it’s important not to panic and quickly sell underperforming investments. This is what often triggers the wash sale rule: Investors react to short-term market changes, and as the market recovers, they buy back their investments.

The truth is if you’ve put a strategic, diversified investment plan together, you don’t need to fear market volatility. Small bumps in the road should not set you too far off course. That’s especially true if you’ve balanced your risk appropriately and followed a long-term plan that includes investments for growth potential and additional financial tools for protection and guaranteed growth, such as permanent life insurance.

Seek help from a financial advisor

If you’ve decided you need to sell an investment, and you’re looking for ways to get your money back into the market, it’s important that you take a step back before taking any action. Selling shares of stock could change your asset allocation, which can impact your investment strategy as a whole. But strategically rebalancing your portfolio to respond to underperforming investments is part of good planning.

Your Northwestern Mutual financial advisor can help you see how your investments fit into your financial plan. And your advisor can help you keep your entire financial picture in view—including your retirement accounts, investments and insurance. Together, you can keep your plan in tune with your financial goals. That will help give you peace of mind that even as the stock market fluctuates, you’ll stay on track.

No investment strategy can guarantee a profit or protect against loss. All investments carry some level of risk, including the potential loss of all money invested.

This is not intended as legal or tax advice. Financial Representatives do not render tax advice. Consult with a tax professional for tax advice that is specific to your situation.