Investors will be delighted to ring out the year of 2022. But as we approach December 31, this awful market has provided a target-rich environment for harvesting tax losses in non-retirement accounts to reduce the toll to Uncle Sam.
It is common and somewhat reassuring to adopt a mindset that doesn't count our losses before they are hatched. Sharp market declines can perhaps be more easily weathered by telling ourselves that we really haven't suffered a loss unless we sell, and for investors with the appropriate long-term view this is a valid perspective. However, there are times in taxable accounts when one can have their cake and eat it too by realizing a loss now to use against future gains, and then repurchasing the position to maintain exposure and benefit from any recovery. The key to success is to avoid a tax trap known as a wash sale.
The wash sale rule exists to prevent taxpayers from deducting losses without a material change in financial position. The rule prohibits selling a security at a loss and buying it back within 30 days, either before or after the sale date.
For example, suppose you had purchased 100 shares of Tesla stock in a brokerage account on November 1, 2021 at a price of $400, for a total of $40,000. On November 1 of 2022 you sold the shares for $20,000, capturing a long-term loss of $20,000. Unaware aware of the wash sale rule, you repurchase the shares a week later for $18,000. Come tax time, the IRS will disallow the capital loss on your 2022 tax return and you will not be able to offset other gains this year.
The rule applies retrospectively as well. Say you owned 100 Tesla shares and purchased an additional 100 shares on October 15, 2022. Your sale on November 1 would violate the wash sale rule. However, had you already owned 200 shares for over 30 days, the partial sale would be deductible.
Note that you could trip the rule unwittingly. Automatic dividend reinvestments into a fund are considered purchases and any reinvestment within 30 days of a tax sale would cause part of the loss to be disallowed. Also, it is important to recall that the wash sale rule applies across all of your accounts as well as those of your spouse. Selling Tesla in a joint account and repurchasing in your IRA or your husband's account (if you file jointly) would fail the test.
Running afoul of the wash sale rule can throw a wrench in your tax planning, but it is not a capital crime. The rule states that while the loss is not allowed, it is added to your new cost basis on the position you repurchased. In our example, your new cost basis on 100 shares would be the $18,000 purchase price plus the $20,000 loss for a basis of $38,000 that will apply to any sale in the future. In essence, you merely delay recognition of the tax loss or reduce future gains.
The IRS does not provide specific guidance as to what qualifies as a substantially identical security, leaving it up to the taxpayer according to their own particular circumstances. However, since the wash sale rule was adopted in 1954, we have a pretty good idea what flies and what doesn't. Individual corporate stocks of a different company clearly pass muster. Also switching classes of the same company like selling the stock and buying a bond is acceptable unless the bond is convertible. One could also replace the stock with a sector mutual fund or ETF that approximates exposure to the same industry and then repurchase the stock after 30 days.
Replacing a fund is a bit trickier. Moving from a passive fund like an equity index ETF into an actively managed fund should generally be ok, but moving into another fund tracking the same index would violate the rule. For example, you wouldn't be able to sell the Vanguard S&P 500 index fund and buy the iShares S&P 500 version, but you could select a fund whose benchmark was similar like the Russell 1000 index. You are also not allowed to switch from a mutual fund to an ETF with essentially the same holdings.
There are some specific rules about how capital gains and losses must be treated when filing your return. First, short-term losses are applied to offset any short-term gains. Next, long-term gains and losses are offset. Thereafter any remaining losses can be applied against either type of gain.
If you still have losses left over, you are generally allowed to offset up to $3,000 against ordinary income during the current tax year and any remaining losses may be carried forward to apply against gains in future years.
And good news for investors in cryptocurrency: the wash sale rule does not apply. Like Sisyphus, you are welcome to take the full loss each time the rock rolls back downhill.
Good riddance to the stock and bond markets in 2022. But at least this selloff presents an opportunity to bank up some future tax assets and make a little lemonade out of a very bitter lemon.
Chris Hopkins is a chartered financial analyst and co-founder of Apogee Wealth Advisors