Wash Sale Adjustments on Short Sales: Major Brokers are Getting it Wrong

Published: February 13, 2013
Tagged: Wash Sales, Trader Taxes, 1099-B

Some major brokers have taken a troubling position in the way they report wash sales on the 1099-B for short sales. This caused big problems when taxpayers tried to reconcile and understand their 2011 1099-B reports. But it appears some brokers continue to use this baffling and incorrect method, which will cause more tax reporting problems for 2012 tax year.

It seems that most brokers understand when a wash sale can occur on a short sale. The problem seems to be understanding how to adjust for those wash sales. Here is how one broker explains their method:

"If the transaction that triggers the wash sale is a buy (long), then the disallowed loss is added to the cost of the newly purchased lot." – Yes that is correct.

"If the transaction that triggers the wash sale is a sell (short), then the disallowed loss is subtracted from the proceeds of the short sale." – Here is where we have a problem!

Let's first review what the IRS rules say for reporting wash sales on shorts…

Rules for 1099-B reporting:

2012 Instructions for Form 1099-B, page 7 (instructions for reporting box 3, Cost Basis:

"Short sales. In the case of a short sale, report the adjusted basis of the security delivered to close the short sale." (italics ours)

Note that the cost basis reported is the basis of the shares that closed the short sale. The broker is not supposed to report the sale proceeds of a short sale in the basis column - some brokers messed that part up in 2011, but that is another story!

"Wash sales. If a customer acquired securities that caused a loss from a sale of other securities to be both nondeductible under section 1091 and reported in box 5 of an earlier Form 1099-B, increase the adjusted basis of the acquired securities by the amount of the disallowed loss." (italics ours)

Note that the language clearly indicates wash sale adjustments are to be made to the basis of securities. If wash sale adjustments were to be made on the proceeds of the short sale, why didn't the IRS specify this in the instructions for box 2a (for proceeds), or anywhere else for that matter?

Rules for taxpayer reporting:

2012 IRS Publication 550, page 59 (instructions for wash sales when reporting capital gains and losses):

"If your loss was disallowed because of the wash sale rules, add the disallowed loss to the cost of the new stock or securities (except in (4) above). The result is your basis in the new stock or securities." (italics ours)

No exception is given for adjusting the proceeds on a short sale. It is the cost basis that gets adjusted by adding the amount of the disallowed loss.

Which method is correct?

Based on the rules both for broker reporting (1099-B) and for taxpayer reporting (on form 8949) it seems pretty clear that wash sale adjustments are to be made to the cost basis in all wash sale situations. And just to be clear, for a short sale the cost basis is the basis of the security delivered to close the trade.

Why would brokers take the position of subtracting the adjustment from the proceeds instead of adding to the cost basis? It may be that the broker's systems are simply unable to handle this accounting. For example, when you open a new short sale that triggers a wash sale, the broker knows that a wash sale has been triggered, but they don't know the final cost basis because you haven't closed the short sale. By adjusting the proceeds they have a way of accounting for the wash sale immediately. This makes sense for their system, but it is not accurate tax accounting.

Consider a basic example in which a second short sale triggers a wash sale:

The two original trades are shown below.

Figure 1

According to the IRS rules, the wash sale adjustments should be made as shown in the Correct Method below. Notice that the basis of the second trade has been adjusted for the wash sale amount.

Figure 2

Finally, here is the Incorrect Method for adjustment some brokers are using. Note the adjustment for the wash sale was made to the proceeds of the second trade.

Figure 3

Let's analyze the two methods: although the net gain/loss is the same, you will notice that the total cost basis and total sale proceeds are not. This creates a reconciliation nightmare for those taxpayers who do what they are supposed to do – keep their own records to use for tax reporting. And ultimately, the broker made incorrect tax adjustments according to IRS rules.

Ideally, the IRS says you should be able to use your 1099-B to fill out Form 8949, then go back and make any adjustments to correct the reported cost basis by your broker. In the case of brokers using this method every wash-sale-adjusted short sale is now incorrectly reported. For active traders this means major cost basis adjustments that must be reported on Form 8949. And since the 1099-B does not provide the details regarding where exactly the wash sale adjustments were applied on any trade, it is nearly impossible to reconcile what the broker has reported.

Bad news, and good news for traders:

Once again we see a major problem with the new 1099-B reporting requirements. Brokers are being asked to be accountants in making complex wash sale adjustments. Taxpayers are given the heavy burden of trying to reconcile and correctly report based on taxpayer rules (which differ from 1099-B rules). It makes us wonder: wasn't the new 1099-B supposed to make tax time easier?

The bad news: 2012 reports are not looking any different than 2011. Early indications are that major brokers are still making the same incorrect short-sale adjustments.

The good news: TradeLog has been correctly reporting wash sales on short sales for over a decade. TradeLog is the trusted solution by leading tax experts and CPAs, and is used by thousands of active traders to generate accurate, IRS-ready tax reporting based on taxpayer rules, not botched 1099-B reports! Learn more on our home page

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.