Wash Sale Rule – Definition

Cite this article as:"Wash Sale Rule – Definition," in The Business Professor, updated July 29, 2019, last accessed October 26, 2020, https://thebusinessprofessor.com/lesson/wash-sale-rule-definition/.

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Wash-Sale Rule Definition

In the United States, the Internal Revenue Service (IRS) created the wash-rule as one of the regulations in trade market. The wash-sale rule maintains that any security, stock, bond or option sold in a wash sale is not tax deductible, this rule prohibits the deduction of tax on such security. In a wash sale, a trader sells a security at a loss with the aim of buying back the same security or an identical security within 30 days of sale. This is to enable the trader claim a capital loss on the investment.

A Little More on What is the Wash-Sale Rule

In the stock market, investors use was sale as an approach to claim a tax deduction on profits made for a particular year, this approach is a cheat. However, the wash-sale rule was established as a way of preventing investors from claiming inelastic losses and tax deductions.

This means that a security sold in a wash sale can be denied tax deduction. Also, when profits are made by investors, they are taxed. Normally, a wash-sale takes a period of 60 days, including 30 days before the sale and another 30 days after the sale. The wash-rule is a regulation of IRS that prevents unfair tax deductions on securities sold in wash sales.

What Constitutes a Wash Sale

Generally, in a wash sale, an investor sells a security at a loss and repurchases the same security or an identical security with 30 days of sale. Ordinarily, the IRS does not regard stocks and securities of company as identical except in cases where a company’s preferred stock can be converted to a common with no barrier. According to the wash-sale rule, if a company or an investor sells a security at a loss to repurchase the same or and identical security at the same price, tax deductions of such security would not hold.

Here is an example of the wash-sale rule in practice; If Investor A buys 500 units of shares from company XYZ at $25 per unit and sells the shares in a wash sale to $21 only to repurchase then at $24 within 30 days, the wash-sale rule will disallow any capital loss that inventors wants to claim on the shares.

Since the was-rule stipulates that tax deductions will be disallowed on a stock sold in a wash sale, a trader (investor) who is a taxpayer is required by the IRS to include the loss in the wash sale to the cost of the new security purchased. The loss incurred by the buyer when selling the shares at $21 per unit will be added to the cost of repurchasing the shares at $24 for tax purposes.

References for “Wash-Sale Rule

Academic research for “Wash-Sale Rule

New twists on an old plot: investors look to avoid the wash sale rule by harvesting tax losses with exchange-traded funds, Fischer, G. M. (2010). New twists on an old plot: investors look to avoid the wash sale rule by harvesting tax losses with exchange-traded funds. Wash. UL Rev., 88, 229.

Exchange-Traded Funds and the Wash-Sale Rule: New Twists on an Old Plot, Meziani, A. S. (2006). Exchange-Traded Funds and the Wash-Sale Rule: New Twists on an Old Plot. In Exchange-Traded Funds as an Investment Option (pp. 143-160). Palgrave Macmillan, London.

[PDF] Insider Trading Around Stock Price Overreactions and the Impact of the Sec’s Wash Sale Rule, Ang, J. S. (1996). Insider Trading Around Stock Price Overreactions and the Impact of the Sec’s Wash Sale Rule. Journal of business.

[CITATION] After the market’s slide, avoiding the wash sale rule becomes’ job one’for investors, Willens, R. (2002). After the market’s slide, avoiding the wash sale rule becomes’ job one’for investors. Journal of Taxation, 97(6), 325-325.

Wash Sales and Stock Options: How Does the Substantially Identical Rule Apply, Emmel, D. M. (1988). Wash Sales and Stock Options: How Does the Substantially Identical Rule Apply. Tax Law., 42, 1073.

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