What is the wash sale rule & how can it affect your investments?

Imagine meticulously planning your capital gains and losses for the year only to realize the tax deduction for losses you anticipated has disappeared. This can happen with the wash sale rule.

Understanding and navigating this rule is important for investors because it can significantly impact your taxes and investment plans.

A wash sale occurs when you sell a security at a loss and repurchase the same security—or a substantially identical one—within 30 days before or after the sale.

The wash sale rule prevents you from using this loss to offset your capital gains. It prohibits people from claiming a tax benefit from selling securities at a loss to turn around and repurchase them soon after to retain their position in the market. Without this rule, investors could exploit the system by selling securities at a loss toward the end of the fiscal year to claim a tax deduction.

This rule applies to several securities, including stocks, bonds, mutual funds and exchange-traded funds (ETFs). It's important to note that the wash sale rule even comes into play if you sell a portion of your holdings and then reinvest the dividends. Both identical securities and substantially identical ones are subject to the rule. The IRS doesn't define "substantially identical," instead stating in Publication 550 that taxpayers need to consider the facts and circumstances.

The IRS does not consider these scenarios substantially identical:

• Stocks of different companies in the same industry.
• Bonds issued by the same institution but with different maturity dates and interest rates.
• Common stock and preferred stock of the same company.

To better understand the practical implications of the wash sale rule, consider a scenario where you own 100 shares of stock in ABC Company. Let's say you bought the shares for $10 per share, or $1,000, in 2019. You sell the shares for $6 per share, or $600, on Dec. 30, 2024, resulting in a capital loss of $4 per share, or $400. When you file your tax return, you plan to use that $400 capital loss to offset capital gains from other investments.

On Jan. 5, 2025, however, you regret selling the ABC Company shares because you think the stock price can rebound, so you repurchase 100 shares at $7 per share. In February 2025, you receive a 1099-B for your brokerage account. But instead of showing a $400 capital loss on the sale of ABC Company in December 2024, the form says "wash sale" and shows no loss. That's because you repurchased the shares of ABC Company within 30 days of the sale.

This example highlights how easy it is to encounter the wash sale rule in everyday investment decisions. Even when it's unintentional and you're unaware, a wash sale can still affect your taxes.

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The wash sale rule doesn't impose penalties in the traditional sense of IRS fines or additional taxes. Instead, it prevents you from immediately recognizing losses on your tax return, which can affect your investment plan and tax liabilities.

However, you don't miss out completely on the impact of the loss. You can add the disallowed wash sale loss to the cost basis of your repurchased security. This can help reduce future capital gains taxes when you sell the replacement security.

Going back to the example above, the wash sale would affect your capital gains tax offset for 2024, but you'll still be able to use the loss to adjust the cost basis of the replacement shares. When you add the loss, your basis in the new shares is $11 per share—the $7 per share purchase price plus the $4 per share disallowed loss from the wash sale.

Here are a few strategies that may help you avoid pitfalls and unexpected tax bills associated with wash sales.

The cornerstone of avoiding wash sales is understanding the 30-day rule. This means not purchasing the same or substantially identical securities within 30 days before or after selling a security at a loss. Planning trades and investments with this window in mind is essential.

The wash sale rule applies to all your accounts, including tax-deferred IRAs and taxable brokerage accounts. It even extends to your spouse's accounts. Selling a security at a loss in one account and repurchasing the same or substantially identical security in another account within the 30-day window still constitutes a wash sale.

Maintaining detailed records of all transactions is a good practice for investment tracking and tax planning, and is essential for avoiding and identifying potential wash sales. While your brokerage agent can identify and track wash sales in the accounts you have with them, they won't be aware of wash sales in accounts you hold with other financial institutions.

Documentation for your transactions should include:

• Dates of trades.
• The securities involved.
• Basis and sales prices.
• Prohibited losses that get added to the basis.

Tax-loss harvesting minimizes taxes on investment gains by strategically selling securities at a loss. These losses can offset capital gains and up to $3,000 of ordinary income per year. You can carry forward any additional losses to future tax years. The wash sale rule directly impacts tax-loss harvesting by setting strict parameters around the timing of securities sales and repurchases.

To maximize the benefits of tax-loss harvesting within the constraints of the wash sale rule, consider these approaches:

• Strategic timing. Wait until after the 30 days is up to rebuy a security if you recently sold the same or a substantially identical security at a loss.

• Diversification instead of replacement. If you sell a security to harvest a loss, think about investing in a different security that serves a similar strategic purpose in your investment portfolio but is not considered substantially identical. Diversifying can help you maintain your market position without violating the wash sale rule.

The wash sale rule can complicate your investment and tax planning. If you're unsure whether it applies to your transactions or how it will affect your tax liability for the year, consider consulting a tax advisor. They can provide personalized advice tailored to your tax situation. Then, connect with a Thrivent financial advisor to help ensure your investment plan aligns with your overall financial goals.