During the recent volatility in the stock markets caused by the coronavirus, investors may face a dilemma in terms of coordinating investment and income tax strategies. An investor may view the crash of the stock markets as an opportunity to harvest capital losses to reduce their income tax liability. Yet, even though a tax loss may be desirous, an investor may still want to retain a stock because of the belief that the stock will rebound.
Such an investor must understand the “wash sale” rules in order to maximize the expected tax benefit of realizing a capital loss.
Generally, a taxpayer who realizes a capital loss can use the loss to offset any capital gain realized in the same taxable year, and if the capital loss fully offsets capital gains (or if the taxpayer has no capital gains), then $3,000 of capital losses can be used to offset the taxpayer’s ordinary income.
The wash sale rules contained in Internal Revenue Code Section 1091, however, will restrict the aforementioned uses of capital losses for a taxpayer who wants to harvest a tax loss with respect to a stock position, and yet maintain the position. Under the wash sale rules, a taxpayer cannot recognize a loss on the sale of stock or securities if the taxpayer acquires, or enters into a contract to acquire, substantially identical stock or securities within 30 days (either before or after) of the sale date. The disallowed loss, however, is not permanently lost, as the disallowed loss is added to the basis of the reacquired stock or securities, meaning that the disallowed loss will be recognized upon an eventual sale of the reacquired stock or securities.
To illustrate, assume an investor owns 1,000 shares of stock that he purchased for $10 per share, giving him a total basis of $10,000. The investor now sells all 1,000 shares when the stock is selling for $4 per share, realizing a loss of $6,000. Assume further that the investor later becomes confident that the stock will rebound and, therefore, purchases 1,000 shares of the same stock at $7 per share less than 30 days after selling the 1,000 shares.
Because the investor repurchased the 1,000 shares within 30 days of selling the 1,000 shares, the wash sale rules will prevent the investor from claiming the $6,000 loss on his tax return. The amount of the disallowed loss, however, is added to the basis of the 1,000 shares that were repurchased, meaning that his basis in those 1,000 shares is $13,000, instead of only $7,000. Thus, if the investor were to subsequently sell the 1,000 shares for $15 per share, his recognized gain would only be $2,000, instead of $8,000. The $6,000 disallowed loss, therefore, provides a tax benefit upon the eventual sale of the repurchased shares.
Thus, investors must be aware of the wash sale rules during these uncertain economic times when coordinating their investment and income tax strategies.
If you have any questions, please contact Douglas Turner Coats.
Douglas Turner Coats
410-576-4002 • firstname.lastname@example.org
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