One Sale That Can Cost You

Lynn R. Siewert AIMC
Pension Consultant | Branch Manager
Advanced Corporate Planning, Vancouver, Washington

In today's market, experiencing a fluctuation in your investments, whether up or down, may be a common occurrence. As the market moves, some investors look for potential investment and income tax opportunities.

One such possibility is to realize income tax benefits by taking a capital loss when an investment drops in value, relative to the initial investment. This is by no means a complicated strategy, but what if the investor wishes to re-establish his or her position in the investment immediately after the loss is realized? There may be a trap waiting for those who are trying to garner an income tax benefit from this type of sale.

For example, suppose an investor purchased 200 shares of X Company for $50 per share and after one year its market price is $35 per share, an unrealized loss of $15 per share. He or she is still comfortable owning the stock and, yes, a little disappointed at the current value, but believes that the stock's price will rebound over the long term.

Since there is an unrealized capital loss - a paper loss - the investor may have decided to realize the loss to "gain" an income tax benefit. Can the investor sell X Company stock, immediately repurchase it, and take the capital loss on his or her income taxes? The answer, surprisingly, is no.

A "wash sale" occurs when an investor sells a security at a loss, and either has acquired or acquires it during a period beginning 30 days before the sale and ending 30 days after the sale of a substantially identical security.

If a wash sale occurs, no capital loss is recognized on the sale of the security. The loss that would have been recognized is added to the basis of the newly acquired security. So in the example above, if the investor repurchased X Company stock immediately after the sale, the capital loss of $15 per share would not be allowed for income tax purposes. The capital loss is not lost but is added to the basis of the newly acquired shares of X Company.

Consider these methods to help avoid the wash sale rule. First, an investor could sell the X Company stock and repurchase it after the 30 days have lapsed. Of course, the stock's price could rise during the 30 days, in which case he or she would miss the potential gain. Second, he or she could buy an additional 200 shares of X Company, hold the 200 shares for the required 30 days, and then sell the initial 200 shares.

The risk associated with this strategy - commonly referred to as doubling up - is in a continued price decline, the investor would sustain a loss on both the original shares and second set of shares purchased. Third, instead of buying back X Company stock, he or she could buy the stock of a similar company (e.g., Y Company). The risk of using this strategy is that X Company and Y Company, although similar, may not be perfect substitutes for each other.

The basic principle of the wash sale is that an investor cannot purchase a security or "substantially identical" security and realize an income tax benefit without being exposed to economic risk for a 30-day period, either before or after the sale of the original security. The wash sale rule applies not only to the sale of stock but also to other financial assets such as bonds and market options.

Of course, this brief article is no substitute for a careful consideration of all the advantages and disadvantages of this matter in light of your unique personal circumstances. Before implementing any significant investment or tax planning strategy, please contact your Financial Advisor or tax professional.

Lynn Siewert is the Principal of Advanced Corporate Planning and Branch Manager of the Vancouver, Washington Office of Supervisory Jurisdiction, Licensed through First Allied Securities, Member NASD/SIPC.