Tax Rules on How to Use Proceeds of Stock Sales to Buy New Stocks

The Federal Reserve Board’s Regulation T governs brokerage accounts and requires investors to maintain sufficient funds in a cash account to pay in full for security purchases. A cash account is one in which the trader cannot borrow funds to pay for trades. The general rule is that you cannot use sale proceeds to buy new stocks until the proceeds settle.

Trade Settlement

In the United States, stock trades take three business days to settle. During the settlement period, clearing agents ensure that the required cash and securities are available for final disbursement. If the full amount of cash is not present three days after the trade, the trade fails because of a settlement violation. You can use unsettled sale proceeds to purchase new shares if the cash settles by the new shares' settlement date. In all cases, the buyer's brokerage account must contain on settlement day all the money needed to pay for the new shares. If you violate Regulation T, you broker may have to freeze your account for 90 days, during which time you must have sufficient cash in your account before you enter into a new trade.

Good-Faith Violation

If you buy stock with unsettled funds and then sell the stock before the cash settles, you've committed a good-faith violation. For example, imagine that on Monday you have nothing in your brokerage account except shares of a specific stock, which you sell that morning for $10,000. The trade will settle on Thursday. On Monday afternoon, you purchase a different stock worth $10,000, but sell those shares on Wednesday, a day before the first sale settles and the $10,000 become available. On Wednesday, your broker will charge you with a good-faith violation because you sold the second stock without fully paying for it. Multiple violations within a year will force your broker to freeze your account.

Cash-Liquidation Violation

You commit a cash-liquidation violation if you sell settled securities after the trade date of a new purchase to pay for the new purchase. For example, suppose your brokerage account contains $200 and 100 settled shares of a company -- call it ZYX Corp. -- worth $1,500. On Monday, you purchase 100 shares of another company -- say, CBA Corp. -- for $1,000. On Thursday, the settlement date, you are short $800, so you sell your ZYX shares. However, the cash from the ZYX sale won't settle for three business days, so you've committed a cash-liquidation violation. Multiple violations in a 12-month period will cause your broker to freeze your account.

Free-Ride Violation

A free-ride violation is the most serious and earns you an immediate account freeze. It occurs when you buy stock with insufficient funds. In the good-faith violation, you purchased shares using unsettled funds. In a free ride, you purchase the shares without the required funds, settled or unsettled. For example, you have $100 in your account on Monday morning and purchase $1,000 of a stock, telling your broker you will wire in an additional $900 before settlement. On Thursday, you instead sell the stock, but it is too late -- you're a free rider.

Margin Account

If you open a margin account, your broker will lend you money to help finance your trades, so you might avoid some settlement violations. However, Regulation T also says that you can only borrow 50 percent of a stock's purchase cost, so a margin account is not complete insurance against a settlement violation.

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About the Author

Based in Chicago, Eric Bank has been writing business-related articles since 1985, and science articles since 2010. His articles have appeared in "PC Magazine" and on numerous websites. He holds a B.S. in biology and an M.B.A. from New York University. He also holds an M.S. in finance from DePaul University.

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