NIBM - Tax Talk - The Wash Sale Rule Part Two

Tax Talk: Navigating the IRS Wash Sale Rule - Part Two

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August 25, 1999 Bret A. Espey, CPA, Espey Accounting Services

Ed. Note: This is the second in a three part series. Check out part one by clicking here.

"Get out the magnifying glass"

In the last tax talk, I laid out the basic rules regarding the wash sale. To summarize, a wash sale occurs when you sell a particular lot of stock at a loss, then either 30 days before or after that sale, you buy another lot of a substantially identical security. If this occurs:

You do not get to claim the loss on your income tax return right away,
The loss is added to the basis of the new shares you purchased, and
The holding period of the new stock is the same as the holding period of the old stock

So, after that disheartening bit of news, you think, "what else do I need to know?" C’mon, this is the IRS! There’s always fine print, you know.

In this issue of Tax Talk, I want to lay out the definition of a substantially identical security (It may not be what you think.) Then I want to go over a couple common circumstances that make the rule tricky to apply. Finally, there is a situation where you lose the loss permanently. I strongly suggest you re-read Tax Tips 1 before you continue.

1. "Substantially Identical What?"

Remember that the wash sale rule applies only if the stock you purchase within the wash sale period is a substantially identical security. That’s a statement ripe for interpretation and misuse, so clarification is in order.

First, there’s the most obvious definition: it’s a purchase of the same stock. If you sell America Online and buy Earthlink (both providers of Internet services), those are NOT identical securities. You must purchase the same stock for the rule to be triggered.

This situation actually ties in to one of the tax tips I gave in Issue 1. You can avoid the wash sale rule by purchasing a security that moves in the same general direction as the stock you sold, but just not the same stock. Buying Yahoo! or Disney may be a good move if you feel it generally moves in concert with AOL-Time Warner. Such a strategy has its own type of risk of course, but it’s a way to avoid the wash sale rule.

Ah, but here’s a good example of when this "trick" may not apply – when one company is about to be bought out by another.

Example 1: Let’s assume you own stock in company A which just bought company B for stock. Before the merger is completed, you sell A at a loss and buy B hoping to avoid the wash sale rule. However, this where the rule gets a little squishy. Because the two stocks are so closely linked (because A paid for B in stock), movement in one will most likely affect the other, tax courts may treat these stocks as substantially identical securities and the wash sale rule would apply. The rule is even more "squishy" if A paid for B with cash.

The point is, don’t just apply the rule blindly – understand what environment the stocks are in.

Mutual funds also pose a weird, but common, dilemma. What if you sell the shares in Fund A (which is indexed on the DJIA) at a loss, and purchase Fund B from another company (also indexed to the DJIA) within the wash sale period. Is the purchase of Fund B a substantially identical security to Fund A? Many opinions diverge from here, and there is no clear answer in tax law. The conservative answer (and probably the correct one in the eyes of the IRS) is that they ARE substantially identical because the sale and subsequent repurchase doesn’t change your investment position enough to claim the loss. Others may tend to be more aggressive, take the loss, and let case law decide, especially since in this example the funds are from two different companies.

There are also a new "proxy" securities called "Diamonds" or "Spiders" available to investors. Some investors who have money in an indexed mutual fund are closing that fund and buying the corresponding proxy security. For example, if you have a mutual fund tracking the S&P500, you could sell it and buy a tradable security with the ticker SPY. SPY is the S&P 500. If you sold your mutual fund at a loss on October 29 to buy SPY on November 11, that might be a wash sale and the loss from the sale of the mutual fund would be added to the basis of your purchase of SPY. If you apply the same theory we did under the mutual fund scenario, the two are substantially identical securities. Again, there are both aggressive and conservative schools of thought here.

Proxy securities called Diamonds and Spiders may also create wash sale situations with your index mutual funds.

It gets worse. Let's say you own Amgen and sell it at a loss. Two days later, you decide you do not want to be out of the biotech sector and buy the Biotech Holder (BBH) -- of which Amgen happens to be a component. According to current thinking on the matter, you have just created a wash sale!

Why? Good question. It has to do with a unique feature of the Holders: You can call Merrill Lynch (who issues the Holders) and by paying a small fee have them break each Holder into its component parts. That special ability has led most tax accountants to conclude the IRS will consider the purchase of a Holder to trigger a wash sale if you sold one of their components at a loss within the wash sale period. We would argue the BBH is not a substantialy similar security to Amgen, but the ability to break the BBH into its component parts tips the scales.

If you were to buy a contract for the AMEX Biotech Index, which also contains Amgen, most tax professionals would not consider that to trigger a wash sale. Why? Because you can't get at the component parts of the AMEX Biotech Index so they are not considered substantially similar securities.

2. Choices, choices, choices…

People also scratch their head when they have multiple sales and purchases of stock within the same time frame. When in doubt, remember to always apply the rule chronologically, and you’ll be set.

Example 2: Joe Sells 100 shares of Microsoft on July 23^rd for a $400 loss. He sells another 100 shares on July 29^thfor a $300 loss. He purchases 100 shares of Microsoft on August 1^st. Joe did not purchase or sell any other Microsoft shares that year. Although it would be nice to have the rule apply to the 2ndsale (so the larger loss would be allowable), Joe will need to apply the rule to the first sale, so his disallowed loss is $400. Joe would claim the $300 loss from the July 29^th sale on his tax return as it is unaffected by the wash sale rules, even though it is within the wash sale period.

This also applies when you have multiple purchases during the wash sale period. You should apply the rule in the same manner – chronologically. The first purchase within the wash sale period triggers the rule, and is treated accordingly:

Example 3: Joe owns 100 shares of IBM. On May 2^nd, he buys another 100 shares of IBM. On May 5^th, he buys another 100 shares of IBM. On May 20^th, he sells the original 100 shares of IBM at a $50 loss. We know the May 20th sale is a wash sale (because there were purchases within 30 days before the sale, and the sale resulted in a loss), and we consider the first purchase (on May 2^nd) as having triggered the rule. The disallowed loss of $50 will be added to the basis of the 100 shares purchased on May 2^nd, and the holding period of the May 2^nd shares is now the same as the holding period of the shares sold. The May 5^th purchase is unaffected by the wash sale rules even though you purchased them within the wash sale period.

Here’s another typical situation: What if you sell 100 shares, but only buy 50 more shares within the each wash sale period. Then the rule only applies to 50 of the 100 shares sold.

Example 4: Joe sells 100 shares of Microsoft on June 2^nd at a $200 loss. He purchases 50 shares of Microsoft on June 29^th. Only half the loss from the shares sold ($100) would be disallowed. The remaining $100 would be an allowable loss on Joe’s tax return.

Whew, I’m getting tired. But there’s one more thing to cover:

3. "You can’t win for losing around here…"

There is one way you can permanently lose the benefit of a wash sale loss…

Let’s say you had a loss subject to the wash sale rules, and that loss was added to the basis of the replacement stock. If you die before you sell the replacement stock, your heirs get no benefit from that adjustment to the basis. You also lose the loss when calculating your final income tax return. This one may not as bad as it seems, because your heirs will usually have a basis in this stock at its fair market value at the date of death. If the stock has been held for a long time, the fair market value is usually higher than the basis of the stock prior to death anyway. (Besides, you’re DEAD at this point…will you really care?)

NEXT TIME…….Wash Sales Part III

Options: the sometimes misunderstood security that may be subject to the wash sale "bite"

Wash sale rules and short sales

The definition of a "trader", and how this might affect your application of the wash sale rules

THANKS – I’m interested in your questions and comments. Perhaps there is a particular tax question you’d like to ask. Send it my way and I’ll see if we can’t incorporate that into future articles. If I get enough questions I may provide a "question and answer" forum in the future. You can contact me by

The tax advice given here is based on an interpretation of the laws at the time the article was written, and should not be construed as advice given by NIBM. The above interpretation is based upon best information and an analysis of then-current interpretations of the tax code. The strategies discussed may not apply to your particular situation. We strongly suggest speaking with a tax advisor for specific questions and before making specific trading decisions based upon the information covered in this article.