It's the Season: for Watching Wash Sales

Published: December 4, 2012
Tagged: Trader Taxes, Wash Sales

Watching Wash Sales

Wash sales can happen all year long, but wash sales that occur in December and January are the ones to watch. Why? Because wash sales that happen in December and January can potentially increase your taxable capital gains for the year! In this post I’ll review what a wash sale is and their potential negative effect. Plus, I'll illustrate how to use TradeLog to monitor wash sale effects on your trades.

What is a wash sale? A wash sale happens when you close a trade at a loss and, within 30 days before or after that loss, you open another trade in the same security (or an option contract on that security). The tax laws state that you cannot take the loss on the original trade. Instead, the loss is washed and attached to the cost basis of the replacement shares which triggered the wash sale. In a nutshell, this is a wash sale. We explain more details in our online Wash Sales Tax Topic – including special rules for wash sales between taxable and non-taxable accounts.

Since most traders are in and out of the same security throughout the year, wash sales are usually inevitable and almost unavoidable.

Most wash sales in taxable accounts do not hurt your net gain or loss for the year, except in two situations:

  1. Wash sale deferrals attached to positions held open at year-end. If wash sale losses are attached to positions that are still held open at year-end you will not get to take those losses until the position is closed – in a future tax year.

  2. Wash sale deferrals attached to January trades. If you close a trade at a loss in December and you have no other positions open you might think you get to take those losses. However, if you then open another trade on that same security in January of the next tax year, it may trigger a wash sale, and your December loss now moves to the next tax year.

Either of these two situations can result in less taxable losses then actually occurred for the given tax year. And sometimes this can really hurt!

For example: Let’s say for 2012 I have a net short-term loss of -$2,500. However, because of the wash sale situations described above, I have $4,000 in short-term losses deferred to the next tax year.
The math: -$2,500 net loss + $4,000 deferred to the next tax year = $1,500 taxable gain.
Here is the problem: Even though I actually lost money, I will have to pay capital gains taxes on $1,500 in short-term gains!

I’ve known traders who had to pay taxes on tens of thousands of dollars in gains even though they had a net loss for the year. This is why it’s worth watching wash sales in December and January.

TradeLog software can help you see wash sales that are affecting your account. Here are some reports and tools to help you:

Don’t forget, new trades you open may trigger a wash sale! If you have recently incurred losses and you are concerned about disallowing them, then you may want to consider the consequences. You might use the various filters in TradeLog to examine your trading closer.

A word of caution: some traders can get overly concerned about wash sales to the point that they make poor trading decisions or even stop trading.

The best advice I’ve seen: If you think you can make a profit in the stock then keep trading! Stop trading when you realize that the stock isn’t going to be profitable for you and perhaps you are accumulating losses already. Again, if you do realize you are going to have a negative tax consequence at year-end then you may make some trading decisions based on that fact.

I’ve covered a few basics about wash sales, and why to watch them in December and January. TradeLog not only generates tax reporting with necessary wash sale adjustments, but it can also help you keep track of wash sale effects before the tax year is over!

We have more comprehensive information on wash sales in our online Tax Topics.

Please note: This information is provided only as a general guide and is not to be taken as official IRS instructions. Cogenta Computing, Inc. does not make investment recommendations nor provide financial, tax or legal advice. You are solely responsible for your investment and tax reporting decisions. Please consult your tax advisor or accountant to discuss your specific situation.