The Wash Sale Rule Explained

What is a wash sale?

A wash sale occurs when an investor sells stocks or assets at a loss and books tax benefits, but makes any acquisition (purchase, automatic reinvestment, vesting.) of the same or substantially identical stock or asset within 30 days before or after the sale. In such cases, the investor cannot get a tax deduction on investment losses.

Read our blog post on tax loss harvesting.  

Why does this rule exist?

The wash sale rule exists so that investors do not sell stocks or assets to gain a tax write-off while essentially retaining their investment in the security.  

Example of a wash sale

• You buy 20 stocks of Acme Corp for $50 per share. Your cost basis is $1000.
• After one year, Acme’s stock falls down to $30 per share. You sell all 20 stocks for $600 realizing $400 in capital losses. 
• You can apply this $400 in losses to offset any other capital gains you may have accrued this year (and potentially upto $3000 of ordinary income), thereby reducing your taxes.
• Where wash sale rules kick in: However, if you buy substantially identical Acme stocks within 30 days before or after this sale , for example, 20 stocks for $35 per share this would be considered a wash sale. The $400 in loss is not allowed for this tax year.

However, the loss on the original tranche of Acme that you sold is added back to your cost basis for the new stock. Now the cost basis for new stock is $700+$400 = $1100. This will potentially help with reducing taxes in the future by reducing taxable gains or increasing losses when you do eventually sell the new shares of Acme.

FAQs about wash sales

1. Does the wash sale rule apply to a spouse?

The wash sale rule applies to the transactions of your spouse regardless of whether you file jointly or separately. Make sure to co-ordinate your tax loss harvesting with your spouse to avoid inadvertently triggering a wash sale.

2. Do wash sales apply to retirement funds (401K, etc)?

Yes, wash sales are evaluated across all your accounts, both taxable and tax deferred. So if you sell an ETF at a loss and buy a substantially identical ETF in your 401K, it will still be regarded as a wash sale.note that if the replacement purchase happens in an IRA or 401(k), the capital loss is permanently lost and cannot be recovered later.

3. How does RSU vesting impact wash sales?

• If you sell company RSUs at a lower price than the price at the time of vesting, you can claim a loss for tax purposes.
• However, RSU vesting within a 30-day period before or after the original sale counts as a wash sale.
• The loss from the original sale will be added to the cost basis of the new RSU vesting if both transactions are in taxable accounts. so if you decide to sell the newly vested RSUs in the future, they will have the new costs basis of cost basis at vesting + deferred loss from sales of the original RSUs.

Therefore, you need to time your stock sales in a way that the sales are not within a 30-day period of vesting of new RSUs. This works when companies have quarterly RSU vesting. 

But when vesting happens every month, then this will not work. In such cases, the losses from your sale of the original tranche will get carried forward and help you mitigate taxes when you sell in the future when there are no wash sales. If vesting replaces only part of the shares sold, the wash sale applies pro-rata, not necessarily to the full loss.

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