NIBM - Tax Tips - The Wash Sale Rule Part Three

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

This article is brought to you by:

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

Ed. Note: This is the third in a three part series. Check out Part One and Part Two.

"The Final Frontier"

Here it is – Part III of the Wash Sale rules (you were hanging on the edge of your seats, weren’t you?) In the last tax talk, I expanded the definition of "substantially identical securities", and highlighted some specific issues on multiple sales and purchases that every trader runs into. I suggest you re-read Tax Talk I and II again before reading further, because I’m building on that groundwork.

In this issue of Tax Talk, I want to talk about two specific types of purchases, and where they fit in with the Wash Sale rules – options and short sales. I also want to begin a discussion on the definition of a trader, and what this means, not only for the wash sale but also for stock purchases in general.

1. Options, options, options……!

There are two ways an option can work, and each one of them pose different wash sale issues. These rules may apply regardless of the source of the option (i.e. purchasing them, or receiving them as an employee).

Call Options:

Let’s start with the basic call option, or an option to buy shares at a certain price. A call option is considered a "substantially identical security" for purposes of the wash sale rule, all the time, every time. The wash sale is triggered if, within 30 days before or after the sale of stock at a loss, you buy an option to purchase additional shares of that stock.

The rule is triggered when you buy the option, not when you actually exercise it. In fact, the wash sale still applies even if you never exercise the option.

Example 1: On July 3^rd, you sell 200 shares of Microsoft at a loss. On July 23^rd, you buy a call option to purchase 200 shares of Microsoft. The loss from the original sale of stock is disallowed, even if the options are never exercised.

Put Options:

Selling a put option (one you sell to someone to give him or her the option of selling you stock at a stated price), is a little trickier as far as the wash sale is concerned. The wash sale rule applies if it is likely the put option will be exercised.

Example 2: You sell a put option for 100 shares of stock in XYZ company for $100 per share (a $100 strike price). The current market price of XYZ is $50. This put option will most likely be exercised, because Joe can buy, right now, 100 shares for $5,000, and sell them to you for $10,000. It is very likely Joe will do this, so this option can trigger the wash sale rule.

I know what you’re thinking…. "Bret, you nincompoop! Why is the wash sale rule triggered when you sell a put option? You didn’t buy the option, you sold the option. I thought the wash sale rule only applied if another purchase occurred within the wash sale period?" A great question, but one that can be refuted by the twisted logic that is the IRS. To them, if you sell an option to someone to sell you shares, and that option is likely to be exercised, that means it is likely you will buy more shares. Remember, The wash sale rule is triggered when options are bought or sold, not when they are exercised. The option date, plus the likelihood of buying more shares means you, Joe Taxpayer, gets hosed - isn’t that grand? (the IRS’ logic astounds me……)

What about selling the options themselves at a loss, then buying another option or actual stock within the wash sale period? This could also be considered a wash sale, although this is an area of law that appears to be fuzzy. Kaye Thomas of Fairmark Press states "The treasury has yet to issue regulations under this rule, and a host of questions remain unanswered. Foremost…is the question of when one option is substantially identical to another". The bottom line: there are rules, but no guidance. Basically, if you sold an ABC call option at a loss, then within the wash sale period bought ABC stock, bought another call option to purchase ABC, or wrote up a put option for ABC that was likely to be exercised, there could be a wash sale. Yikes!

2. "Short sales got no reason to liiive……"

Okay, so my headline writer was out today. Randy Newman can sue me – I ran out of ideas. Let’s talk about the short sale instead...

Ah, the short sale! The pessimists’ dream security play! You are betting that a stock will drop, so you borrow some stock from someone, and you sell it. Some time in the future, you buy stock back so you can repay the "lender". You hope that the price has dropped since you sold it. What would happen, though, if you have a loss on a short sale?

My goal here is to summarize the high points of the short sale rules. They are tricky.....what I discuss below may not touch on every short sale rule or situation. As always, make sure to look to your friendly neighborhood tax advisor for guidance.

"Vanilla" Short Sales

In a typical short sale, you borrow shares from someone, sell them on the open market, then buy replacement shares and give them back. In this case, the rule appears to apply in reverse of what you would think for the wash sale.

It stands to reason that if a normal wash sale is triggered if there’s a purchase within the wash sale period, a short sale loss could be a wash sale if another sale is made within the wash sale period, determined by the closing of the transaction. For wash sale purposes, the transaction is closed when stock is purchased and given back.

This is my interpretation, because to me it’s difficult to fathom a scenario where you would buy stock back and close the short, then buy more stock as a regular purchase, all for the sole purpose of cranking out a loss and holding a position (which is what the Wash Sale Rule is supposed to prevent). However, some interpretations I’ve seen suggest that it doesn’t matter whether you enter another short position, or purchase additional stock, the rule would be triggered.

My point is, just make sure you are cognizant of the rule when you enter into a short sale.
Short sales "against the box"

In this scenario, you sell the borrowed stock, then replace it with stock you already owned. In this case, the IRS may look at this as a "sale" of the stock you already owned, and the wash sale rules would apply normally. In other words, if you sell short against the box and use already-existing shares to replace the ones you borrowed, and this produces a loss, you may have a wash sale if you purchase additional shares within the wash sale period. Again, the wash sale period is triggered at the point you deliver the shares to the person you borrowed them from. And again, there are differing opinions on what triggers the wash sale rule.

3. Trading (and I don’t mean Pokemon cards)….

The definition of a "trader" is something that we will need to discuss over two sessions. My goal in Tax Talk III is to talk about how the wash sale rule may apply to a trader. It’s a little unorthodox to talk about how a rule applies to something without fully defining what that something is, but this is my "tease" for you to read the next article!

Basically, you can be three things in this world when you buy and sell stocks: an investor, a trader, or a dealer. I don’t plan on telling you what a dealer is today (and no, I’m not talking about the gal who cleaned your clock at the blackjack table the last time you were in Vegas.) We’ll stick to the definition of investing and trading.

The following may define you as a trader:

You buy and sell stocks regularly, and you have many buys and sells over the year
Your very existence depends on you making money at your trades (i.e. it’s your only real job)
You are not receiving your main income source from dividends
You make your money based on short term market swings

If you don’t meet all of these tests, chances are you are "merely" an investor.

If you are a trader, there are many regulations which change for you, including what you can deduct on your tax return, how you deduct it, and other issues. The wash sale rule can also be applied differently to you.

If you are a trader, many regulations change for you.

In general, you will apply the wash sale rules the same whether you are a trader or investor. Traders, however, can take a special election, thanks to the Tax Relief Act of 1997. If you are considered a trader, you may elect to count all your trades as "Marked to Market".

What’s that mean? It means you play pretend. You "pretend" that you sold all your stock for fair market value on December 31^st. If you have losses as a result of this paper transaction, they are not considered losses for wash sale purposes. Only actual sales are looked at in terms of the wash sale rule.

There are other advantages and, yes, disadvantages to being a trader and making the "Mark-to-Market" election. We will explore these in a future Tax Talk.

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.