Wash Sale Rule Explained: Tax Loss Harvesting for Stocks and Crypto by Katie St Ores CFP

[00:00] This video is about the wash sale rule, what it is, when it applies, and why there is one. I have a couple of examples, and yes, I have you crypto guys covered.

[00:12] Special thanks to Jennifer from Columbus, Ohio for requesting this video. I'm Katie St. Orres, Certified Financial Planner and Licensed Tax Consultant. Let's get going! This information is for educational purposes only and does not replace personalized tax advice.

[00:30] If you sell a stock, fund, or other security at a loss, and then buy the same or a substantially identical security within 30 days before or after that sale, the IRS will not allow you to claim that loss on your taxes.

[00:46] That's the wash sale rule in its simplest form. It exists to prevent investors from selling a losing position just to harvest the tax loss, then immediately buying right back in as if nothing happened.

[00:59] The rule applies to stocks, bonds, mutual funds, exchange traded funds, and options. It applies in taxable brokerage accounts. It applies whether the repurchase happens in your account, your spouses account, or even your IRA.

[01:16] The IRS looks at the whole picture. The 30-day window runs in both directions. 30 days before the sale, 30 days after the sale. That is a 61-day window total where you cannot repurchase substantially identical securities if you want the loss to count.

[01:34] Many investors only think about the 30 days after and they get caught by the 30 days before. And here is where it gets interesting. Most people think a disallowed loss is a lost loss, but that is not how this works at all.

[01:51] When a wash sale is triggered, the disallowed loss is not gone forever. It gets added to the cost basis of the replacement shares. This is important. Your loss is deferred, not destroyed.

[02:05] When you eventually sell those replacement shares in a way that does not trigger another wash sale, you will get the benefit of that original loss at that time. Here is an example. You buy 100 shares of a technology stock at $50 per share.

[02:20] Your cost is $5,000. The stock drops and you sell at $35 per share for $3,500. You have a $1,500 loss.

[02:32] But 20 days later, you buy back the same stock at $32 per share. The wash sale rule triggers. Your $1,500 loss is disallowed for this tax year.

[02:45] That $1,500 does not disappear. It gets added to your $3,200 repurchase cost, giving you an adjusted cost basis of $4,700 on your new shares.

[02:59] Here is the silver lining most investors miss. The holding period of your original shares carries over to your new shares. So if you held that original stock for 11 months before selling, you only need to hold the replacement shares for one more month to qualify for long-term capital gains treatment.

[03:20] The clock does not reset to zero. That can make a meaningful difference in the tax rate you pay when you eventually sell. Let's say you own shares of a broad market index fund. Call it Fund A.

[03:34] And you also own a very similar index fund from a different company. Call it Fund B. That tracks the same index. You sell Fund A at a $3,000 loss on December 15.

[03:47] You want to stay invested in the market so the next day you buy Fund B. Has a wash sale been triggered? It depends on how similar these funds are. The IRS uses the term substantially identical.

[04:02] Two funds tracking the exact same index using the exact same methodology are likely substantially identical. Two funds tracking different indexes, even if they both hold large US companies, are generally not considered substantially identical.

[04:21] This is the tax loss harvesting strategy. You sell the losing position, immediately buy something similar enough to maintain your market exposure, but different enough to avoid the wash sale rule.

[04:35] And you lock in the loss for tax purposes. An S&P 500 fund and a total market fund, for example, have significant overlap but are typically not considered substantially identical.

[04:49] That is a commonly used swap. If you sell a stock at a loss and then buy a call option on that same stock within the 30-day window, the wash sale rule triggers.

[05:04] Options on a stock are considered substantially identical to that stock for wash sale purposes. You cannot use options to get around the rule. Your tax professional can help you identify appropriate replacement positions for your specific holdings.

[05:22] Let's talk about the wash sale rule and your retirement accounts. This is where a lot of investors make an expensive mistake. If you sell a stock at a loss in your taxable brokerage account and your IRA purchases the same stock within the 30-day window, the wash sale rule applies.

[05:40] Your IRA is considered a related account. The reason this is particularly painful is that the disallowed loss does not get added to the basis inside the IRA the way it would in a taxable account.

[05:52] With an IRA, the loss is simply gone permanently. You lose it completely. So be especially careful about automatic reinvestment and dividend reinvestment programs inside retirement accounts that might be purchasing the same securities you are harvesting losses on.

[06:09] Also worth noting, the wash sale rule applies to substantially identical positions across your portfolio as a whole, not account by account.

[06:21] Keep that in mind if you manage money in multiple places. We have covered the core rule, the IRA mistake, and the options angle. Now let's bring it all together with crypto.

[06:33] Now let's address the crypto investors directly because this is where the rules are different and where they may be changing. Under current regulations, the wash sale rule does not apply to cryptocurrency.

[06:45] The IRS currently classifies crypto as property, not as a security. The wash sale rule applies to stocks and securities. That means right now, under the latest laws, a crypto investor can sell bitcoin at a loss on Monday, buy it back on Tuesday, and still claim that loss.

[07:05] This is a significant tax advantage that crypto holders have over stock investors. This is being used actively and intentionally by sophisticated crypto investors. It is called crypto tax lost harvesting, and unlike with stocks, there is currently no waiting period required.

[07:23] You can sell and repurchase the same coin the same day. One important caution though, while there is no 30-day rule for crypto under current law, make sure your trades have real economic substance, meaning you are actually exposed to market risk for a period of time, even if brief.

[07:41] A sale and an instant repurchase with no real risk in between could draw IRS scrutiny under broader tax principles. The intent of the transaction matters, and this brings me to the bigger caution.

[07:54] Legislation has been proposed multiple times to close this loophole entirely. Under current regulations, it is still allowed, but this is an area to monitor closely. What is permitted under the latest laws today could change, and given how much attention crypto taxation is receiving, that change could come.

[08:13] If you are doing crypto tax loss harvesting, document everything. Keep clear records of every sale date, every repurchase date, the price at time of sale, and the price at time of repurchase.

[08:25] Clean records will protect you if the rules change. Let's walk through a real dollar scenario on the crypto side so you can see exactly how the tax savings actually works in practice.

[08:38] Imagine you purchased Ethereum at $3,000 per coin. The price has dropped and it is currently trading at $2,000. You hold 5 coins.

[08:50] Your total loss is $5,000. Under current regulations, you sell all 5 coins on a Thursday. You have a $5,000 realized loss. Friday morning, you buy 5 coins back at $2,000.

[09:07] You now have the same position you started with. But you have locked in a $5,000 capital loss that you can use to offset capital gains elsewhere in your portfolio.

[09:19] Or up to $3,000 per year against ordinary income if your losses exceed your gains. That $5,000 loss could offset $5,000 in stock gains you realized elsewhere this year.

[09:35] If those gains were long-term gains taxed at 15%, that is a $750 tax savings. If they were short-term gains taxed at your ordinary income rate, the savings could be significantly higher.

[09:51] Your new Ethereum has a cost basis of $2,000 per coin. If Ethereum later recovers to $3,000 and you sell, you will owe tax on that gain at that time.

[10:03] The tax savings was real. You simply shifted when you pay tax on the appreciation. There is one more area where the wash sale rule quietly catches investors.

[10:16] And it happens every single year in December. One more layer worth understanding. The wash sale rule and mutual funds at year end. Many mutual funds distribute capital gains near the end of the calendar year.

[10:30] If you are holding a fund that is sitting at a loss and you are also receiving a capital gains distribution from that same fund, you are in a difficult position. Selling the fund to harvest the loss means you will need to wait 30 days before buying back in.

[10:46] During those 30 days you are out of the market in that position. Some investors time this by selling right after the distribution date, then waiting the full 30 days before repurchasing.

[10:58] That is a legitimate strategy. Just make sure the fund you sell and the fund you buy as a temporary replacement are not substantially identical. Also, if you buy shares of a fund shortly before it distributes a capital gain, you will owe tax on that gain, even though you have not held the fund long enough to benefit from the appreciation that created it.

[11:20] This is called buying the dividend. Check distribution dates before purchasing mutual funds late in the calendar year. Before we close, I want to give you a few practical steps you can take right now to make sure you are protected.

[11:36] Your brokerage is required to track wash sales for identical securities within the same account and report them on your form 1099B. They are not required to track wash sales across multiple accounts or between your taxable account and your IRA.

[11:52] That tracking responsibility falls on you. Tax software does a reasonable job catching wash sales within a single account but may miss cross account violations. If you are doing any active tax loss harvesting, consider working with a tax professional who can review your full picture across all accounts.

[12:12] For crypto, most major exchanges do issue tax forms but the quality of those forms vary significantly. If you are trading across multiple exchanges or wallets, use crypto tax software specifically designed to aggregate your activity.

[12:27] The IRS has been increasing enforcement in this area and clean records will protect you. Finally, the goal of tax loss harvesting is not to avoid taxes. It is to manage the timing of when you pay them.

[12:41] The losses you harvest today become the gains you report tomorrow when your positions recover. The strategy pays off when you are moving short term gains, taxed as ordinary income, into long term gains taxed at lower rates or when you are in a high income year and need to offset gains that you could not avoid.

[13:01] Here is what you need to take away from this. Three key points and if you remember nothing else from this video, remember these. First, the wash sale rule disallows a loss when you sell and repurchase the same or substantially identical security within 30 days before or after the sale.

[13:21] The losses deferred to your replacement shares, not eliminated, and the holding period of your original shares carries over. Second, the wash sale rule applies across accounts including IRAs and losses lost to an IRA wash sale are gone permanently, not deferred.

[13:41] Third, under current regulations, cryptocurrency is not subject to the wash sale rule, giving crypto investors a tax loss harvesting advantage that stock investors do not have.

[13:54] But legislation to change this has been proposed and should be monitored. Thanks for watching. I'm Katie St. Orres. See you for my next video where I talk about everyone's favorite subject, taxes.

[14:06] This information is for educational purposes only and does not replace personalized tax advice.