It is a well known fact that capital gains taxes significantly lower long-term investing results. Naturally, most investors want to lower their tax bill. Sometimes, investors sell assets that have fallen below the purchase price, allowing them to claim a capital loss. The IRS, however, has very specific rules on capital losses. By knowing and understanding the wash sale rule, you can make sure you do not inadvertently run amuck of the law.

The wash sale rule defined

Put simply, the wash sale rule prohibits an investor from claiming a capital loss for tax purposes if the investment in which the loss originated is repurchased within thirty days.

An example of a situation applicable to the wash sale rule

Imagine an investor unfortunate enough to purchase Lucent Technology stock when it was trading upwards of $70 per share. Over subsequent years before the firm disappeared mergers, that investor watched accounting scandals, financial trouble, and sales meltdowns wipe the share price down to $1. Ever the enterprising baron, our investor realizes that if he sells his shares, he can report a capital loss and lower his tax burden. The problem? He believes Lucent, or the firm that ultimately owns it, will rise from the ashes and return some of the market value which it has lost.
Suddenly, our investor gets a brilliant idea. During the last week of December, he calls his broker and tells him to sell his shares in the telecom equipment supplier, locking in the capital loss.

Three weeks later, during the first half of January, he calls the broker and instructs him to repurchase those shares of Lucent. All is well in the world; he locked in his capital loss while holding onto the shares. Seems ingenious, right?

The IRS is one step ahead of him. The wash sale rule, as you remember, does not allow an investor to claim a capital loss if he repurchases the investment within thirty days. In other words, unless the investor waits until the thirty day period has elapsed, he will not be able to write the loss off his taxes thanks to the wash sale rule. To add insult to injury, Lucent may run up during the time he is waiting on the sidelines, increasing the price at which he buys. The fact that he has now paid two commissions (one for selling in December and one for repurchasing in January) is equally as unappealing.

Getting around the wash sale rule

?Couldn?t the investor have waited for the wash sale period to expire then repurchase the shares?? you may ask. As a matter of fact, yes, he could. As mentioned before, there are several problems with this approach. Besides the double commissions, there is a very real risk that Lucent will run up in the short term causing him to repurchase at a higher price which may be significantly more than he planned. The moral? Only sell if you accept the fact you may not be able to repurchase the shares in the future at the same or lower price. If you are reconciled with this possibility, there?s nothing stopping you.

More information

For more information on capital gains tax holding periods and related concepts, visit the guide to capital gains taxes resource.