What Is The Wash Sale Rule ?

What Is The Wash Sale Rule ?

The IRS permits you to use trading losses to offset gains, plus an additional $3,000 against ordinary income, with the remainder carried forward indefinitely to future years.

However, opening a new "substantially identical" position within 30 days before or after the closing transaction, activates the wash sale rule. The rule states that the loss is to be moved forward from the closing transaction to the new opening transaction, essentially delaying the deduction.

Inconsistency
You may question why it should even matter when you take the deduction. After all, the wash sale rule does not mean that you lose the loss deduction, only that you delay it.

In fact, the tax system includes thousands of rules which permit delaying the payment of taxes, like spreading income out over several years. Why should this be any different ? You are not alone in questioning this inconsistency.

Issues
The issue with the wash sale rule is that there is no consensus even among experts on the details of when it is required.

For example...

What is the requirement on no-effect wash sales ?
What exactly is a "substantially identical" position ?
What are the rules for daytraders ?
What impact do multiple accounts make ?

Take the first issue. Suppose you activate the wash sale rule and move the loss deduction forward all within the same year, so that there is no net effect on your taxes. Is it really necessary to go through all the effort when there is no tax change ?

This is a matter of debate and interpretation of the law. The IRS states that you cannot "claim" the deduction. What does that mean, though ?

The meaning of "claim" suggests an improvement in your tax situation. This is why some people support the position that only end of year wash sales should be reported, and the rest simply cause confusion, not just for the taxpayer, but for the IRS as well.

Others believe that every single wash sale should be reported, even thousands of them which have no effect on the tax owed. It should be noted, though, that many from the report-every-wash-sale camp may have a vested interest in their position, like providers of wash sale software products, or tax accountants looking for more clients.

Intention
The application of the wash sale rule requires some level of manual interaction. In addition to the unresolved issues and differing opinions on wash sales, it is the intent of the transaction itself which is at the very heart of the rule.

The wash sale rule only exists to prevent the taxpayer from taking a loss without really closing out the position. The rule was not implemented for daytraders, but for investors. Yet, the rule does not differentiate between daytraders and investors, and so the confusion remains.

Avoidance
The simplest way to avoid the wash sale rule altogether, is not to purchase replacement securities during the 61-day window of the closing transaction.

Daytraders can elect to report using mark-to-market, which completely frees them from the wash sale rule, but there are other consequences which result.

IRS
The only goal of the IRS is to make sure that everyone pays what they owe.

Consider the following tax scenario. Suppose that you make two errors on your tax return. In the first error, you underpay by $100, and in the second you overpay by $500. Also suppose that the IRS catches both errors, and is aware that the net effect is an overpayment of $400.

Since the result is that you overpaid, do you think the IRS will notify you, just to let you know that you are due a $400 refund ? Doubtful. The general point is that the IRS is only interested in collecting the amount you owe, not correcting your return.

Therefore, whatever your position on the wash sale rule, just make sure that you pay what you owe, and the IRS will be happy.

Conclusion
It is very unlikely that the IRS is waiting to go after upstanding citizen "Joe USA" for failure to report wash sales within the same calendar year which have no net effect on the overall tax owed. Just like law enforcement does not focus on drivers who are 4 miles per hour over the speed limit, the IRS has higher priorities.

It is far more likely that the IRS would be more "interested" in people who fail to report all of their income, like freelance work or tips. Even the failure to report $50 of interest might make the IRS suspicious of what other income is missing.

Report all sales transactions, adjust amounts for wash sales that impact your taxes, and pay what you owe. Enough said.