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Wednesday, February 23, 2011

Wash sales and worthless stock

Wash sales are a term given to the repurchase of securities such as stocks within 30 days prior to and following the selling of securities at a capital loss i.e. at a price lower than the price purchased. Such sales may be implemented to avoid 'worthless' securities transactions despite the wash sale rule. The wash sale rule is implemented by the U.S. Internal Revenue Service that disallows tax benefits usually afforded to financial losses incurred through capital loss on investments.

The tax benefits lost due to a wash sale may be regained at a later time through a basis adjustment in which the loss on the sale of a financial instrument is added to the purchase price of the wash purchase. (www.fairmark.com) This is an important adjustment to note as overlooking it within a given tax year could lead to an over reporting of capital gains. The Kiplinger video below explains how the wash sale rule works and is used for tax purposes:

Calculating disadvantages of the wash sale rule


If the tax savings loss is greater than the potential capital gain incurred through an upward price movement following a wash sale, then the wash sale may not be profitable. In other words, for a wash sale to be financially prudent the repurchasing of securities should ideally lead to a profit greater than the tax savings incurred through a tax deduction on the loss of sale. To calculate the potential worth of a wash sale following specific steps may be helpful.

• Identify tax bracket
• Estimate adjusted gross income after the sale of securities
• Calculate tax savings using adjusted gross income estimate and tax bracket 
• Forecast potential capital gain on wash sale 
• Subtract estimated tax savings from forecasted capital gain

Securities affected and not affected by the wash sale rule


Wash sales do not apply to every exchange of securities within a 60 day period. In the case of certain financial instruments, the repurchase of securities either 30 days before or after a sale are not considered wash sales. Furthermore, according to the IRS, wash sales do not apply to the following items (www.irs.gov)

Financial Instruments not affected by the wash sale rule:

•Foreign exchange purchases and repurchases
•Futures contracts
•Non-equity options
•Dealer equity, or securities futures contracts

Financial Instruments affected by the wash sale rule:

• Purchase and sale of stocks through an individual retirement account (IRA)
• Sale of stocks through an options contract
• Purchase of similar types of securities ex-stocks of two similar oil companies
•Options contracts involving repurchase of the same stock

Wash sale tips


When entering into a wash sale a few considerations may be useful in one's financial management strategy. A few of those tips are provided below with the purpose of clarifying the potential benefits and disadvantages of wash sales.

• Time of year: If the wash sale takes place early in the fiscal year, the cost basis adjustment may offset the tax loss if a cost adjusted capital gain of equal proportion to the capital loss is incurred. Additionally, since wash sales only apply within a 60 time period, adjusting securities purchases outside of this time frame may be beneficial.

• Type of security: In the case FOREX and futures securities transactions the wash sale rule may not have an impact in which case such purchases and sales may have less tax implications

• Size of transaction: Depending on the size of the transaction the wash sale rule may incur relatively little or larger financial impact. For example, 1) a forgone capital loss that may have lowered tax filing bracket, 2) a large enough transaction in which the tax benefit loss is significant

• Investment & Tax strategy: Incorporating the potential for wash sales into one's investment and tax strategies can be useful in maximizing gains and minimizing losses. Considering the potential implications of purchases may lead to a more developed approach.

The wash sale rule is a part of the U.S. federal tax code and disallows tax benefits for the loss of various securities such as stocks and option contracts in the event an additional purchase of that or a similar security takes place within a 60 day time frame. Certain limitations exist for this rule including the basis adjustment calculation and purchase of securities not included in the wash sale rule. 

Calculating the potential loss from a wash sale involves the estimation of adjusted gross income, tax bracket, potential tax savings and capital gains and losses. Incorporating and understanding the rules of the wash sale into one's overall investment and tax strategy can be a useful in one's individual financial planning.

Sources:

1. http://www.irs.gov/publications/p3991/ch01.html
2. http://www.fairmark.com/capgain/wash/ws101.htm
3. http://www.irs.gov/pub/irs-pdf/p550.pdf