The loss from the sale or disposition of stock or options is not deductible if, within a period beginning 30 days before or 30 days after the sale that generated the loss (a 61 day window), the investor acquires substantially identical shares or contracts or acquires a contract or option to buy substantially identical stock. (IRS Publication 550)
Wash sales ONLY apply to losses. Therefore, if there is a gain on the disposition of stock or options, by definition there is no wash sale.
Basis - the cost basis of the newly acquired stock or option that triggered the wash sale is INCREASED by the disallowed loss.
Holding period - the holding period begins for the new stock or option on the same day as the securities sold.
These are complicated calculations which are exacerbated when options are exercised or assigned during the course of a trade.
What are Wash Sales?
Wash Sales are definitely the nemesis of the trader/investor so it is discussed extensively on this website.
So what are“substantially identical” securities?
If you want to avoid the wash sale rules, particularly when trading options, you need to know what a substantially identical security is and if it applies to your loss sale.
The term “substantially identical” is not defined in the Internal Revenue Code or Regulations.
Obviously, selling 100 shares of Apple at a loss and replacing it with 100 shares of Apple within the 61-day window (30-days before and 30-days afterward) is a wash sale.
The same is true for options. If you sell an Apple Jan 2018 150 Call at a loss then repurchase that same option within the restricted time frame - it would apply to puts as well - you would have a wash sale.
Note: The loss is not gone forever. When the investor/trader no longer holds that security for more than 30 days, the suspended loss can be used against other gains or deducted against ordinary income according to the capital loss rules.
Mary-Kate and Ashley Olsen from ABC's "Full House"
But what about mixing stock and options, or options with different strikes and expirations, or replacing stock with an ETF?
These are only a few of the potential pitfalls but click here to examine this further.
An investor purchases 100 shares of IBM on 4/18/20Y1 and 100 shares on 5/4/20Y1 for a total of 200 shares. On 6/9/20Y1 the investor purchases 100 more shares, on 7/5/20Y1 he sells 200 shares and then purchases 100 more on 7/28/20Y1.
Essentially this investor has employed a stock acquisiton principle known as "dollar-cost averaging" or the purchasing shares of a stock while it is decreasing in price in order to bring the average cost basis down. If it is a dividend-paying stock the dividend yield will therefore be more attractive.
Wash sales can become the undesire side-effect of this stock acquisition strategy, especially while engaged in a covered call strategy.
This example is partially taken from actual trades while using a covered call investment strategy.
We will ignore the effect of the covered calls for this example. Here are the resulting tax ramifications:
Wash Sale Example:
Planning for the Wash Sale Rule
What are “substantially identical” securities?
This is basically a facts and circumstances determination. The purchase of another company’s stock in the same industry is not considered substantially identical. However, the purchase of a call on the same stock would be. Take a closer look by clicking here. The purchase of the iShares Financial Services Index ETF (IYG) would be similar in characteristics but would not qualify as substantially identical to the SPDR Financial Select Sector ETF (XLF).
Literal adherence to the rules is always an alternative. Simply wait 31 days before purchasing the same security again. With volatility in the market, you may get it for a bargain!! This makes sense if the stock has dropped and earnings will be reported the following month. But it only really matters in December, ie, the loss transaction occurs in December and the wash sale is triggered in January by the purchase of substantially identical securities - two separate tax years. The December loss is not recognized.
Selling a put?
Good thinking! Publication 550 seems to describe the triggering of a wash sale with the purchase of stock or an option, ie, a call. However, the Internal Revenue Code, Sec 1091(a) states that if “the taxpayer has acquired ... or has entered into a contract or option so to acquire, substantially identical stock or securities ...” then no deduction shall be allowed. Further, the IRC goes on to say that stock or securities “include contracts or options to acquire or sell stock or securities” which clearly rules out the purchase of a call but maybe not the sale of a put. Click here to see some examples.
If your spouse or an entity which you control repurchases loss securities within the 61-day window, a wash sale is created. This also includes Individual Retirement Accounts. With regard to the spousal transaction, presumably this is true even if you are married filing separately or you reside in a non-community property state and the wash sale is triggered with separate funds.
Note: The “Date Acquired” on the Wash Sale line is the purchase date of the shares that created the wash sale, NOT the new holding period date. The holding period extends back to the original purchase date of the shares sold and should be kept separately for your records.
Congress enacted the wash sale rules to curb abuses by large investors taking a loss on a stock and then turning around and buying the same stock back. Essentially a timing issue, the investor receives a large tax benefit but is in the same economic position as before because he still holds the stock.
It is my opinion that the wash sale rules are - as is most of the tax code - too complex for the average investor and that a threshold amount should be established for lower income or trading levels.