How to Avoid Violating Wash Sale Rules When Realizing Tax Losses

Harvesting losses on taxable investments is a strategy that helps reduce taxable income and also boost your return. To recognize a capital loss for tax purposes, you have to actually liquidate the position during the tax year. (See also: Comparing Long Term vs. Short Term Capital Gain Rates.) Any unrealized loss on an investment cannot be deducted.

A lot of tax loss selling happens towards the end of the calendar year, but it’s worth paying attention and capturing tax losses throughout the year as you rebalance or replace positions in your portfolio. Losses are used first to offset other taxable capital gains. Then up to $3,000 for a married couple filing jointly ($1,500 for an individual or married filing individually) per year can be used to offset other taxable income. For example, you realize $5,500 in long-term losses during the year and at tax time use $2,000 to offset other capital gains and $3,000 to offset ordinary income. If your long-term capital gain rate is 20% and your effective federal tax rate is 25%, the $5,500 loss is reduced by $1,150 plus a savings on state taxes (if applicable). Then the $500 unused loss can be carried forward to future tax years. Unfortunately losses do not transfer at death. (See also: Does Tax Loss Harvesting Really Work?)

When recognizing tax losses, you do have to be careful that you do not trigger a wash sale. A wash sale is when an investment is sold at a loss and the same or a "substantially identical" investment is purchased either 30 calendar days before or after the sale. If that happens, a wash sale has occurred. With the new cost basis reporting rules that the IRS has put into effect, more and more investors are going to find themselves having made wash sales. (See also: How Taxpayers Can Do A Legal Wash Sale.)

When a wash sale occurs in a non-qualified account, the transaction is flagged and the loss is added to the cost basis of the substantially identical investment you purchased. If you continue to trade the same or similar investment, the loss gets carried forward with each transaction until the position is finally fully liquidated for more than 30 days. The holding period of the investment (short- or long-term capital gain) is determined by including the original purchase (or purchases) sold at a loss. Unlike other taxable gains and losses, a wash sale is not tied to a specific calendar year and the rules limit when an investor can recognize those losses.

The wash sale rule applies to stocks, bonds, mutual funds, ETFs and options (any investment with a CUSIP number) in non-qualified brokerage accounts and IRAs.

Stocks, preferred stocks and options of different corporations, as well as bonds with different issuers, are viewed by the IRS as not substantially identical. However, IRS Publication 550 does note that corporations may be considered substantially identical if they are a predecessor or successor corporation in a reorganization. The rules also apply to short sales.

According to IRS Publication 564, mutual funds are not viewed as substantially identical to funds issued by another company. Many mutual funds and ETFs, such as an index funds, can have very similar holdings. So far the IRS has not really focused on mutual fund and ETF wash sales.

When an investor has several accounts, including IRAs and Roth IRAs, wash sale rules apply to the investor rather than to the account. IRS regulations require brokers to track and report wash sales of the same CUSIP number in the same non-qualified account. However, investors are responsible for tracking and reporting any sales that occur in other accounts (their own and their spouse's) that they control, which may trigger the wash sale rule on IRS Schedule D.

Depending on whether you own individual stock, mutual funds or exchange traded funds, there are strategies you can employ to help manage taxable gains and losses while avoiding a wash sale. (See also: Pros and Cons of Annual Tax Loss Harvesting.)

If you own an individual stock with a loss, but don’t want to be out of the market, one way to avoid a wash sale is by making an additional purchase and then waiting 31 days to sell the shares that have a loss. However, this strategy can increase your sector exposure and risk.

You could also just liquidate the holding, recognize the loss and then immediately buy a similar investment that suits your investment goal or portfolio allocation. Examples include selling Coca Cola and buying PepsiCo or selling the Vanguard Index 500 fund and buying the Vanguard Total Market Index ETF.  

Everybody makes mistakes. But many people hold on to losing positions for years, rationalizing that the investment will recover and ultimately show a profit. It often makes sense to sell positions and reallocate the funds. Harvesting tax losses can help take some of the sting out of incurring taxes on gains or the emotion of admitting that an investment just did not work out.