Legal Definitions - wash sale

A wash sale occurs when an investor sells a security, such as a stock, bond, or mutual fund, at a loss and then repurchases the same or a "substantially identical" security within a specific timeframe. This timeframe is typically 30 days before or 30 days after the date of the sale that incurred the loss.

The primary purpose of the wash sale rule, enforced by tax authorities like the IRS in the United States, is to prevent investors from claiming a tax deduction for a loss while essentially maintaining their investment position. If a transaction is deemed a wash sale, the loss from the sale cannot be deducted for tax purposes in that year. Instead, the disallowed loss is typically added to the cost basis of the newly acquired security, effectively postponing the tax benefit until the new security is eventually sold.

Here are some examples illustrating a wash sale:

• Example 1: Identical Stock Repurchase

  Maria owns 200 shares of "FutureTech Solutions" stock, which she bought for $75 per share. When the stock price drops to $60 per share, she sells all 200 shares, realizing a $3,000 loss. Ten days later, believing the stock will rebound, Maria buys back 200 shares of "FutureTech Solutions" stock.

  Explanation: This is a wash sale because Maria sold shares at a loss and then repurchased the identical shares within the 30-day window. The $3,000 loss she realized from the sale cannot be deducted from her taxable income. Instead, this loss would be added to the cost basis of the new shares she bought.

• Example 2: Substantially Identical ETF

  John holds shares in an exchange-traded fund (ETF) that tracks the S&P 500 index and sells them at a loss. The very next week, he decides to invest in a different ETF from a different fund provider that also tracks the S&P 500 index and has a very similar investment objective and portfolio composition.

  Explanation: Even though John bought a different ETF, it is considered "substantially identical" to the one he sold because both track the same underlying index and aim for the same investment results. Since he repurchased a substantially identical security within the 30-day period after selling at a loss, this transaction would be classified as a wash sale, and the loss would not be immediately deductible.

• Example 3: Related Party Purchase

  Sophia sells municipal bonds issued by "City of Evergreen" at a loss. Twenty-five days later, her husband, Robert, purchases new municipal bonds also issued by "City of Evergreen" in his own investment account.

  Explanation: The wash sale rule extends to sales and repurchases made by a taxpayer or a "related party," which includes a spouse. Because Sophia sold the bonds at a loss and her husband purchased substantially identical bonds within the 30-day period, this transaction would be considered a wash sale for Sophia, and she would not be able to deduct the loss.