The Wash Sale rule is a regulation that prohibits traders from claiming a tax deduction on the sale of a security if they purchase a substantially identical security within 30 days before or after the sale. The rule is designed to prevent traders from manipulating their taxable income by selling securities at a loss and then immediately repurchasing them.
Here’s an example to illustrate how the Wash Sale rule works:
Suppose a trader owns 100 shares of XYZ stock that they purchased for $50 per share. The trader sells the shares for $40 per share, incurring a loss of $1,000. The trader then purchases 100 shares of XYZ stock at $45 per share within 30 days of the sale.
In this scenario, the Wash Sale rule applies because the trader repurchased substantially identical shares of the same security within 30 days of the sale. As a result, the trader cannot claim a tax deduction for the $1,000 loss incurred on the sale of the original shares. Instead, the loss is added to the basis of the new shares purchased at $45 per share, reducing the potential gain or increasing the potential loss on the new shares.
It’s important for traders to be aware of the Wash Sale rule when selling securities at a loss, as violating the rule can result in penalties and fines from the Internal Revenue Service (IRS). Traders can avoid violating the rule by waiting at least 30 days before repurchasing substantially identical securities after selling them at a loss, or by purchasing different securities that are not substantially identical.