Retirement Accounts

Wash Sales in Individual Retirement Accounts

Wash sales can occur at anytime - except if a Mark-to-Market election is in place.

One particularly onerous IRS position is that a wash sale is created when substantially identical securities are purchased inside an IRA or Roth IRA within the 30-day before/after parameter when a LOSS in a TAXABLE account is sustained.

So let’s examine this scenario and how the IRS has created a mess from which it cannot easily extricate itself.

Example

You are trading AVGO inside a taxable account.

Let’s say the price of AVGO falls to such an extent that there is virtually no premium in the calls that are equal to or above the price you paid for AVGO. Therefore, you decide to use the market to determine what your strike price* and you choose a short call strike at one standard deviation above the current price but still below your cost basis. AVGO recovers and exceeds your short call strike and you are exercised for an overall loss on AVGO.

You decide to begin trading AVGO inside an Individual Retirement Account (IRA) with a longer-term horizon since it is still below its normal trading range.

You buy AVGO inside your IRA within 30 days of experiencing the loss on AVGO in your taxable account.

Congratulations … you have just created a Wash Sale inside your IRA!!

According to the Wash Sale rules, the loss is added to the basis of the newly acquired substantially identical securities, in this case, the 100 AVGO shares inside the IRA. (We will ignore the holding period rules)

So, now those AVGO shares inside the IRA have basis.

When the investor/trader ultimately begins to take distributions from the IRA, how is that basis recognized? Otherwise, if no basis is reflected in the IRA, the loss is never recognized.

You cannot quickly purchase AVGO in your taxable account because the Wash Sale adjustment is on the first shares purchased after the loss transaction.

Possible Solutions

Facts: For the following possibilities, let us assume that you traded AVGO in a taxable account. Your basis in 100 shares of AVGO is $55,000 and you sold it for $53,000 on July 21, 2023 resulting in a loss of $2,000. You believe that AVGO will increase substantially over the next several years and would like to have it in your retirement account. You purchase 100 shares of AVGO for $52,500 on August 14, 2023. You have no other trades in AVGO.

The loss should attach to the August 14, 2023 shares so that your actual basis is $54,500 (purchase price of $52,500 + Wash Sale loss of $2,000) - ignoring commissions. But, according to IRS Revenue Ruling 2008-5, this is not the case. See below.

The following represent some of the possible remedies to this situation, without Rev Rul 2008-5:

The possibility should exist to report the basis on Form 8606. So if you made a $4,000 contribution to your IRA and the Wash Sale loss attributed to your IRA is $2,000 then you would have a $4,000 IRA deduction on line 32 of Form 1040 (Tax Year 2014) and a Non-Deductible amount of $2,000 on Form 8606. (Example 1)

However, if you have already made the maximum contribution to your IRA for the year and you report a non-deductible additional contribution on Form 8606 you could then be subject to an excise tax of 6% on the excess contribution per year as long as the excess contribution remains in the IRA. You would report the excess contribution on Form 5329. Alternatively, you could withdraw $2,000 from your deductible IRA before the filing deadline, including extensions. You are also required to withdraw any earnings on the excess contribution. (Example 2)

The last possible solution would be to keep track of the Wash Sale outside of any IRS reporting. Upon ultimately taking a distribution you will receive Form 1099-R from the brokerage with an amount in Box 1 of the Gross Distribution and the same amount in Box 2 Taxable Distribution. You can adjust Box 2 for the pro-rata share of the distribution that has basis and wait for the IRS to contact you. At that time you have an arguable but tenuous defense. (Example 3)

Please Note: The above only represent possible remedies to this dilemma and does not originate from authoritative sources. As such, these scenarios and their corresponding Example tax forms should not be relied upon to file your tax return if you are in this situation. You are advised to seek professional tax advice for your particular situation.

A word about Rev Rul 2008-5

Rev Rul 2008-5 states that the facts used in this example generate only one conclusion, the loss on the sale of stock is disallowed and the basis of the stock in the IRA is not increased as is the case pursuant to IRC Sec 1091(d).

This conclusion is simply WRONG!!

Essentially, a taxpayer sustains a loss on the sale of stock in a taxable account but wants to hold it in his/her retirement account. This Revenue Ruling states that the LOSS is NEVER deductible in the taxable account nor is the basis adjusted for the stock in the retirement account.

Trading Technique

Use the Market

* What I mean by “using the market to determine what your strike price” is simply a matter of using the following formula for days to expiration and implied volatility and choosing a strike price that is about one standard deviation away from the current price. One standard deviation encompasses approximately 68% of the possible movement of the underlying during the period of the projected trade - or 34% of the possible one-way movement of the stock.

Example:

TSLA is trading at 982.13

Your trading horizon is 22 days and the Days In Year are 252 (trading days)

The average At The Money (ATM) Implied Volatility for the puts and calls is 29.65

The expected movement is +/- 86.04 points

One standard deviation encompasses 68% of the possible movement of an underlying security - 34% below the mean and 34% above the mean