Under Internal Revenue Code Sec. 1001, gain or loss realized on the sale or exchange of property is the excess of the amount realized over the adjusted basis. If one purchased 100 shares of Exxon in August, 1993, and sold them on December 26, 1993, realizing a loss of $1,000, one would expect that this loss would be reported on Schedule D of the taxpayer’s 1993 tax return as a short term capital loss. In many cases, this is indeed the tax treatment of such a stock sale.
Suppose, however, the same individual repurchased 100 shares of Exxon during the period from December 26, 1993 until January 25, 1994. In this case, the loss would be disallowed in its entirety, since the repurchase, within 30 days of the sale, would have triggered the wash sale rule. Under Code Sec. 1091, no deduction is allowed for a loss incurred on the sale or exchange of a security where “substantially identical” securities are acquired within a 61-day period beginning 30 days before the date of the sale and ending 30 days after the sale.
“Substantially identical” is narrowly defined to mean stock of the same corporation. Therefore, the wash sale rule would be inapplicable if the individual in our example had, after selling Exxon, instead purchased Mobil stock within the 30-day period commencing on December 27. Mobil could then be sold after 30 days, and Exxon repurchased at that time, without triggering the wash sale rule.
Would the loss on the Exxon stock disappear if the individual instead repurchased Exxon within the prohibited time frame? No, Code Sec. 1091 does not permanently deny the loss on the stock involved in the wash sale; rather, the loss is postponed until the replacement stock is later sold. If Exxon were repurchased within 30 days of its sale, the $1,000 of unrecognized loss would be added to the basis of the repurchased stock. If the repurchased stock was itself sold the following day, the $1,000 loss would then be recognized, since the individual’s adjusted basis would exceed his amount realized by $1,000.
What can be done to reduce the impact of the rule? One tactic is to purchase stock of a similar corporation, as noted above. Another alternative entails waiting until 31 days after sale before repurchasing the identical stock. However, if the stock goes up within this period, the taxpayer would be unable to replace the stock at the initial sale price. In this case, the wash sale rule would have achieved its precise purpose.
Another method of finessing the rule entails the purchase of an additional 100 shares of Exxon on November 27, 1993, 30 days before selling the original 100 shares. The individual could now safely sell 100 shares of Exxon on December 26, recognize the loss, and still have an interest in Exxon. Of course, this method is not without its own risk, since the stock could decline in price from November 27 until December 26. In that case, the taxpayer would have avoided the wash sale rule only to incur an economic loss.
In closing, it should be noted that the wash sale rule may occasionally work to the taxpayer’s advantage: In cases of a poorly timed loss, the taxpayer can invoke the provision by repurchasing the stock within 30 days, thereby postponing the tax loss.