When a stock investor sells a losing security in order to claim a capital loss and then turns around and purchases the same security (or a "substantially identical security") he's made a "wash sale." The namesake "wash-sale rule," also known as the 30-day rule, prohibits investors from making these kind of transaction until 30 days after the sale. As a penalty for initiating a wash sale, they forfeit the ability to claim a capital loss deduction on their income tax returns
Implemented by the IRS, the 30-day rule does not consider another company's securities, bonds and some types of a company's preferred stock "substantially identical" to its common stock.
Selling For Capital Losses
If you sell an investment at a loss, it's called a capital loss and it can be used to reduce your taxable income. Capital losses are credited against any capital gains you have for the year and excess losses can be used to reduce the amount of your regular taxable income. The wash sale rule prevents you from selling shares of stock and buying the stock right back just so you can take a loss that you can write off on your taxes.
The wash sale rule does not apply to gains. If you sell a stock for a profit and buy it right back, you still owe taxes on the gain.
Understanding The 30-Day Limit
The timeframe for a wash sale is 30 days before to 30 days after the date you sold your shares for a loss. If you own 100 shares of stock and you buy 100 more, then you sell the first 100 shares for a loss 10 days later, the loss will be disallowed for tax purposes.
Buying back a "substantially identical" investment within the 30 days triggers the wash sale rule. For example, if you sell stock shares and buy a stock option on the same company, it would trigger a wash sale and invalidate any tax loss from the sale of the shares.
When the Rule Does Not Apply
Shares purchased within 30 days before or after the sale for a loss must be "replacement shares" for the wash sale rule to go into effect. You can buy shares and sell them a week later for a tax-deductible loss because the initial purchase was not intended to replace shares already owned or sold. In most cases, a wash sale is triggered when you sell an investment then buy the same investment again within 30 days after the sale.
Exploring Wash Sale No-No's
You can't try to get around the wash sale rule by buying back the shares in a different account, such as selling shares out of your regular brokerage account to book the loss and then buying the shares in your IRA account. Don't try to bend the rules by selling shares out of your individual brokerage account and buying them in a joint account. These transactions would still be classified as wash sales and the tax loss not allowed.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.