With another tax season now in the rear view mirror, one of the biggest problems that continues to effect trader’s taxes is the wash sale rule. I see it happen every year without fail.
A trader is expecting to report a loss for the year, however due to the wash sale rule, has to report a capital gain and pay taxes on money they technically did not make.
Investors very rarely have to deal with wash sales because there is very little turn over in their accounts. Traders, on the other hand, can have thousands of transactions in a given year, making it very likely that they will be subject to wash sale rules.
If you trade stocks and/or options, you need to be aware of the wash sale rule. More importantly, this article will explain how to “free” yourself from being subject to wash sales in the future.
WHAT IS THE WASH SALE RULE?
According to the IRS Publication 17, a wash sale occurs when you sell or trade securities at a loss and within 30 days before or after the sale you:
1. Buy substantially identical stock or securities
2. Acquire a contract or option to buy substantially identical stock or securities
3. Acquire substantially identical stock for your IRA or Roth IRA
If your trade falls within these rules, you are subject to the wash sale rule and your loss is disallowed on that transaction. However, the loss does not disappear. The disallowed loss gets added to the cost basis of the new purchase.
EXAMPLE
You buy 1000 shares of XYZ for $10,000 on May 1. On May 15 you sell these shares for $7,500. Then on June 7 (within 30 days of the sell) you purchase 1000 shares of XYZ for $8,000. Your loss of $2,500 on the sale is not deductible. It gets added to the cost of the new purchase of $8,000, making the cost basis $10,500. This process continues until the 30 day window is exceeded.
WHAT ABOUT SHORT SALES?
For purposes of the wash sale rule, a short sale is considered complete on the date the short sale is entered into if on that date:
1. You own (or, on or before that date, you enter into a contract or option to acquire) stock or securities identical to those sold short, and
2. You later deliver such stock or securities to close the short sale
Otherwise, a short sale is not considered complete until the property is delivered to close the sale.
EXAMPLE
On June 10, you buy 1000 shares of XYZ for $10,000. You sell short 1000 shares of XYZ for $7,500 on October 10. On October 11, you buy another 1000 shares of XYZ for $7,500. You close out the short position on November 20. The $2,500 loss is not deductible because the date of entering into the short sale is deemed to be the date of sale for wash sale purposes and substantially identical stock was purchased within 30 days of the sale, making this transaction subject to the wash sale rule.
If you are a short term trader, you most likely have a large number of wash sale violations each tax year, making tax time very frustrating. How can a short term trader avoid the effect of the wash sale rule?
As I have written about in the past, a short term trader can elect Section 475(f), mark to market accounting for their trading business. A trader who elects the mark to market election is no longer subject to the wash sale rule. All your gains and losses for the year are taxed, even your open positions. For more information on the mark to market election, please see my past article here.
SOME CHOICES
In order to make the mark to market election for 2013, you would have had to notify the IRS of your intention by April 15th of this year. If you missed this deadline, you can still make the election by incorporating your trading business as a partnership, LLC, or an S corporation. A new trading entity can make an internal mark to market election, as long as it is done with 75 days of the incorporation date.
Making the mark to market election and taking the step of incorporating your trading business can be complex subject matters. I would encourage all traders considering these steps to seek out the guidance of a qualified tax professional who can explain the benefits and drawbacks as they pertain to your unique situation.
Learn more. Can Traders Deduct Their Health Insurance Costs?
