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ahobbs (27.75)

Beware the Wash Sale

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January 30, 2009 – Comments (2)

Disclaimer:  I am not a tax professional.  The following is my understanding of the IRS wash sale rules, and is compiled from various sources.  Consult a tax professional before acting on any opinions in this blog post.

Many investors will be reporting capital losses in their taxes for 2008.  Unfortunately, the software program that I use to track investments (Microsoft Money) does not keep track of wash sales (I cannot comment on Quicken or other software), so investors will need to be wary of wash sale rules when they report capital gains.  Information on wash sales can be found in IRS publication 550 (see http://www.irs.gov/publications/p550/ch04.html#en_US_publink100010601).

Wash Sale Explained

A wash sale occurs if the two following conditions apply:

1.       The sale resulted in a loss.  Wash sales do not apply to capital gains.

2.       Replacement shares were purchased in the time period composed of the day of the sale, and the 30 days prior to and after the sale date (count the days carefully).  Replacement shares can include mutual funds that invest in equivalent securities (for example, selling a S&P500 fund from one company, and buying an S&P500 fund from another company).  Replacement shares include certain options on the underlying securities.  Use the following table to determine if a wash sale may apply to your situation:

Action Resulting in Capital Loss                Wash Sale if within the wash period

(one of the following):                                (one of the following):

-----------------------------------------------------------        --------------------------------------------------------------

Sell of Stock or Mutual Fund, or                     Buy Stock or equivalent Mutual Fund, or

Sell to close call options, or                           Buy to open call options, or

Buy to close deep in-the-money put options    Sell to open deep in-the-money put options

--------------------------------------------------------------------------------------------------------------------------------

Buy stock to cover short position, or               Short sale of stock, or

Sell to close put options, or                            Buy to open put options, or

Buy to close deep in-the-money call options    Sell to open deep in-the-money call option

For the table above, a wash sale occurs if one of the three actions in the right column is done within the wash period of one of the three actions in the left column of the same row that results in a loss.  The third row is my interpretation of the wash rule for a short position.  I haven’t seen this spelled out anywhere, so you’ll want to talk to your tax professional if one of these situations applies.  Also, the IRS is not clear by what qualifies for “deep in-the-money” options (a deep in-the-money option is one that has a wide margin between the stock price and the strike price, and has a high probability of getting excised).

Further complicating matters, the IRS has recently ruled that wash sales may apply over different accounts, including retirement accounts (See http://www.irs.gov/pub/irs-drop/rr-08-05.pdf).  If, for example, you sold an S&P500 fund at a loss in a taxable account, the sale is a wash if you purchased an S&P500 fund in your Roth IRA within the wash period.  If this is the case, I don’t know how you would transfer that loss in your retirement account, so again, you’d have to talk to your tax professional.  Also, a wash sale can occur if a spouse purchases replacement shares, even if you file your taxes separately, or a corporate entity that you own and have control over purchases replacement shares within the 61 day wash period.

From the viewpoint of the IRS, a person cannot claim a loss if they stand to benefit from any gains of the original position (i.e. purchased replacement shares).  This is the basis for all the rules regarding replacement shares and the co-mingling of funds, stocks, options, and retirement accounts.

Transferring Dates & Losses

Identifying wash sales is the first step in the process.  If a wash sale has occurred in your portfolio, you cannot claim the loss in your federal schedule D – you must indicate the sale as a wash sale and not include the loss in your calculations.  Once you’ve identified that a wash sale has occurred, the next step is to adjust your wash purchase to capture the loss.  The following is an example of the application of the wash sale rule for the sale of stock, but can be extended to include mutual funds, options, and short sales:

1.       From the shares that were sold, calculate the loss on your position based on a first-in first-out (FIFO) basis (unless you’ve specifically instructed your broker to sell specific shares).

2.       Identify the shares that were purchased within the 61 day wash period.

3.       Take the first shares purchased in the wash period.  These shares will inherit the purchase date from the shares sold in step 1.  Add the loss calculated from step 1 to the cost basis of these shares (on an absolute basis, so the cost of these shares will increase).

4.       Repeat step 3 on all subsequent shares purchased in the wash period until you either run out of wash shares sold or shares purchased.

You’ll note that a wash sale does two things: (1) the bought shares inherit the purchase date from the shares sold.  This can sometimes cause a short-term capital loss (higher tax rate) to become a long-term capital loss (at a lower tax rate). Also, (2) the loss is transferred to the shares bought in the wash period, which delays the reporting of the loss until the adjusted shares are sold – sometimes pushing the loss into following calendar years.

A Warning

There are a couple of things an investor needs to be wary about in regards to wash sales.  One is the 61 day wash sale timeframe (the day of the sale and the 30 days prior and after the sale).  If you had any sales in December, you’ll have to wait for your January statement to see if there were any wash sales.  If you have any wash sales that will carry over into the next year, you’ll need to make a note to yourself and place it in next year’s tax file -- it is very easy to forget to carryover the time and cost basis for stocks in subsequent years.

My Advice

My advice in regards to wash sales is simply to avoid them.  Do not sell a portion of your stock holding at a loss if you bought additional shares in the proceeding 30 days.  Do not buy a stock if you sold it at a loss in the proceeding 30 days.  Do not invest in similar mutual funds in your taxable accounts and retirement accounts.  Otherwise, if you do have similar funds and you need to sell your taxable fund at a loss, change your investment allocation in your retirement account so that new investment dollars are not invested in the similar fund during the 61 day wash period (you’ll have to change your allocation at least 31 days prior to selling the fund).

Sometimes, wash sales occur in managed accounts, where you don’t have full control over investment decisions of the manager.  If the manager provides yearly tax reporting statements, but doesn’t report wash sales, request that they provide a complete tax report including wash sales (that should get them thinking twice before trading so frequently).

Otherwise, there is computer software out there that will calculate wash sales for you.  Unfortunately, this feature is not included in the current version of Microsoft Money (I can’t vouch for any Quicken products).  Depending on the quantity of trading and wash sales, these programs can easily be worth the investment.

This tax season, there will be a lot of capital losses reported on Schedule D.  It will be very important to identify and correctly report wash sales this year.

Disclaimer:  I am not a tax professional.  Consult a tax professional before acting on any opinions in this blog post.

2 Comments – Post Your Own

#1) On April 06, 2009 at 11:03 PM, Nolosoft (< 20) wrote:

Do you mind have a look at TradeMax? A full featured tax software specifically designed for active investors or traders who have multiple accounts to manage their trade data, maximize their gain/loss strategy, prepare their Schedule D.
TradeMax® debuts innovative new tools that enable active investors or traders to effortlessly manage all their trades across various accounts.With customizable Vista® style “Views”. TradeMax® delivers important investment account information right to the desktop, without the need to access Internet. Users can manage their trade data, maximize their gain/loss strategy, prepare their Schedule D. It can import trade data from all kinds of formats files, monitor realized/unrealized gains &losses for current positions, adjust wash sales events, report capital gains/losses in printed Schedule D format or export to popular tax software such as TaxCut®, TurboTax®.
All TradeMax® products are available today at http://www.nolosoft.com.

 

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#2) On November 29, 2009 at 11:12 PM, itrademax (< 20) wrote:

new features of TradeMax include

Neutral Trend TradeMax is a full featured Vista style trade software specifically designed for active traders and investors to manage their trade data, optimize their gain/loss strategy, and prepare their Schedule D or Mark-to-Market Form(4797).

The new features of TradeMax include
1.) Track your trades: You can setup different investment type accounts among whole family and manage trade data over years. TradeMax tracks and categorizes trade data and security price automatically. You can view all investment accounts in one place.
2.) Comprehensive Corporate Events Module : Recording various corporate events, such as stock splits, stock merge, spinoff and symbol changes
3.) Powerful importing module: TradeMax has pre-defined profiles support most brokers. TradeMax also provides a flexible format reorganization algorithm which allows you to customize your own format.
4.) Intelligent Option Cost Basis Adjustment Function: Auto- detecting Assigned, exercised and expired option, also defers cost to corresponding shares with its Option Adjustment function.
5.) Handle Wash Sales: TradeMax calculates various Wash Sale scenarios, include but are not limited to, Wash Sale between identical securities (stocks and options), Wash Sales on an unequal number of securities and Wash Sales on Same Day Rule.
6.) Simplify tax preparation: TradeMax can assign short trades and convert short / long position, and calculates Wash Sales automatically. You can generate Capital gains/losses report for Schedule D purpose or export *.txf file to popular tax software such as TaxCut, TurboTax.
7.) Analyze your trading performance: You can analyze your trading performance easily with the help of WashSales Detail Report,Summary Report, Transaction Report and Daily Market Value Report.
8.) Powerful Forex Rate Module:Auto-convert the transactions under Non-USD currency into USD figures.

http://www.itrademax.com

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