A taxpayer cannot deduct the loss realized on the sale of stock or securities (including shares in a mutual fund) if the taxpayer purchases substantially identical stock or securities within the period beginning 30 days before and ending 30 days after the sale (Sec. 1091(a)). The wash-sale rules apply to stock, securities, options, and short sales, but they do not apply to transactions involving foreign currency and commodities futures contracts (Rev. Ruls. 71-568 and 74-218). They apply whether the taxpayer voluntarily or involuntarily disposes of the stock or securities. Thus, the taxpayer must be careful when replacing stock that he or she sold at a loss.
Observation: At first glance, the Sec. 1091 wash-sale rules appear to prevent a taxpayer from ever recognizing a loss when the taxpayer sells shares within 30 days of purchase. Fortunately, Rev. Rul. 56-602 provides that Sec. 1091 is not intended to apply to bona fide sales made to reduce a taxpayer’s holdings of the stock or security. Thus, a taxpayer who buys 200 shares of a stock and within the next 30 days sells 100 shares at a loss will not have the loss disallowed under the wash-sale rules. However, the rules will apply if the taxpayer acquires additional shares within the 30 days following the sale at a loss.
For the wash-sale rules to apply, the stocks or securities must be substantially identical. Ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation.
Some taxpayers have tried to circumvent the wash-sale rules by having a related party purchase the replacement stock or securities. Although Sec. 1091 and the regulations do not apply to related parties, the courts generally have not allowed the loss in these situations ( Shoenberg , 77 F.2d 446 (8th Cir. 1935)). Also, where a taxpayer sells an asset at a loss, and his or her IRA purchases an identical asset within the Sec. 1091 time limits, the purchase by the IRA will be treated as a purchase by the taxpayer and the loss will be disallowed (Rev. Rul. 2008-5).
Taxpayers must also be aware of the Sec. 267 related-party transaction rules. The courts have ruled that the replacement was part of the original plan or, in some cases, that the sale by one taxpayer and the purchase by a related taxpayer should be collapsed into a single related-party transaction, resulting in loss disallowance under Sec. 267 ( McWilliams , 331 U.S. 694 (1947)). However, if the acquisition of an identical asset by a related party “is purely coincidental and is not prearranged,” the transaction is not subject to the related-party loss disallowance rules (IRS Publication 550, Investment Income and Expenses , p. 52 (2012)).
Caution: Unlike Sec. 1091, there is no specific time limit on the application of Sec. 267. If a loss on a sale is disallowed because a related party acquired a similar asset as part of a prearranged plan, the Sec. 267 rules can apply. Thus, merely planning the reacquisition so it is more than 30 days before or after the loss sale will not render the loss deductible. Also, a loss disallowed by Sec. 267 does not affect the basis of any property. Instead, the loss is only beneficial to the extent of any gain realized when the related party sells the asset. If the related party subsequently sells the property at a loss, the previously disallowed loss disappears forever.
In-laws are not related parties under Sec. 267, and, therefore, using an in-law to purchase stock or securities may accomplish a taxpayer’s goal of retaining control and recognizing the loss on the sale of the stock. In community property states, spouses generally each own half of marital property. In those states, using an in-law to avoid the wash-sale rules may be effective for only half of the loss.
A loss that a taxpayer does not recognize under the wash-sale rules is generally deferred; that is, the basis in the substantially identical stock or securities is increased by the amount of the disallowed loss. In addition, the holding period of the acquired securities includes that of the original stock sold.
Example 1: H acquired 100 shares of T Corp. on October 12, 2009, for $30 per share. On November 16, 2011, H buys another 100 shares for $15 per share. On December 5, 2011, he sells his original 100 shares for $12 per share for a long-term capital loss of $1,800 ($1,200 sales proceeds less $3,000 basis). On January 2, 2012, he sells his remaining 100 shares for $16 per share.
Under the wash-sale rules, H cannot recognize the $1,800 loss from the December 5, 2011, sale because he acquired 100 shares of the same stock within 30 days of the sale. Instead, the $1,800 loss is added to the basis of the shares he purchased on November 16, 2011. The holding period of those shares also is added on. When he sells his remaining shares on January 2, 2012, he recognizes a long-term capital loss of $1,700 ($1,600 sales proceeds less $3,300 basis).
A taxpayer can use a wash sale to generate long-term capital gain treatment should the stock increase in value. A taxpayer can also turn a short-term loss into a less desirable long-term loss.
Example 2: In March 2011, J recognized a short-term loss of $2,000 on the sale of 100 shares of Y , Inc., that he purchased in April 2010 (i.e., held for 11 months). Two weeks after the sale, the stock price decreased further to the point J felt he could make money on the stock in the short term. He repurchased 100 shares of Y stock within 30 days of the sale; therefore, the first sale is a wash sale, and the loss is not recognized. The basis in the new stock is adjusted for the disallowed loss, and the 11-month holding period from the first sale tacks on to the new stock.
J sold the Y stock in November 2011 at a $4,000 gain. J is taxed on the gain at the long-term capital gain rate since he is deemed to have held the stock more than 12 months (April 2010–November 2011).
An opposite and less desirable result that might occur because of a wash sale is the conversion of a short-term capital loss into a long-term capital loss. If, in the preceding example, J sold the repurchased stock for a $4,000 loss (rather than a gain) in November 2011, the loss would be a long-term capital loss. Here, the wash-sale rules have converted what would have been two separate short-term capital losses to a single long-term loss.
The wash-sale rules can be particularly troublesome if an investor disposes of several blocks of stock at the same time and repurchases the same stock within the period 30 days before or after the sale. Here, if some blocks generate gains while others generate losses, those generating losses may be disallowed under the wash-sale rules. Even though the sales of the different blocks occurred on the same day, those generating losses subject to the wash-sale rules cannot offset the gains from other blocks (Rev. Rul. 70-231).
Applying the wash-sale rules is fairly straightforward when the transactions involve the sale and purchase of the same stock or security (e.g., IBM stock). The rules are more difficult to apply in situations involving different types of financial investments related to the same security. For example, a loss from the sale of 100 shares of IBM stock followed (within 30 days) by the purchase of a call option for 100 shares of IBM stock will result in the stock loss’s being disallowed under the wash-sale rules. Similarly, a stock loss followed too closely by selling a deep-in-the-money put option on the same stock (i.e., a put with a strike price substantially in excess of the stock’s current market price so there is no substantial likelihood that the put will not be exercised) can result in loss disallowance (Rev. Rul. 85-87).
Although a stock and an option on that stock generally constitute substantially identical securities, they may not be in all cases. Arguably, a put option that is not deep in the money, as discussed in Rev. Rul. 85-87, is not substantially identical to the underlying stock. Practitioners must pay attention to all of a taxpayer’s investment activity when planning for the wash-sale rules.
This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals , 12th Edition, by Anthony J. DeChellis, Patrick L. Young, James D. Van Grevenhof, and Delia D. Groat, published by Thomson Tax & Accounting, Fort Worth, TX, 2011 ((800) 323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger, LLP, in Arlington, VA.