Are you bullish about the stock markets in 2023? If so, you may be looking at year-end strategies to prepare for brighter investing horizons. For example, after the stock market declines of 2022, you may now hold securities—whether stocks, ETFs, or mutual funds—that would generate capital losses if sold. Those losses could then be used to offset capital gains and a limited amount of ordinary income. Called “harvesting” capital losses, this is a popular year-end strategy. But beware: the IRS rules on wash sales can wreck your tax planning.
The ‘Wash Sale’ Problem
In brief, the tax rules let you net capital losses against capital gains on Schedule D of your Form 1040 tax return. Any unused capital losses you can then net against up to $3,000 of ordinary income. Lastly, you can then carry forward any remaining losses to the next tax year. If you think stocks will go up in 2023, you may think it makes tax sense to sell loss-makers now, before the end of 2022, and repurchase those stocks in January 2023 to keep your investment in them.
Here’s where that crafty tax plan runs into trouble. A sale of stock at a loss coupled with the repurchase of the same stock within 30 calendar days after the sale will trigger the wash-sale rules, disallowing, for now, the capital loss. Below are key facts to understand about these rules.
Beware Wash Sales: Seven Points To Know
1. The disallowed loss is not “lost” (with one big exception: see #4 below). Instead, the loss you’re not able to claim on your upcoming Form 1040 tax return is added to the replacement stock’s basis and holding period. If you purchase fewer shares than you sold, the wash-sale treatment applies only to that number of shares (i.e. not the entire number of shares initially sold).
2. While the timeframe for wash sales is often presented as a 30-day window, it’s actually a 61-day window covering the 30 days before and after your sale, regardless of whether that period spans two years. Buying in early January the same stock you sold at a loss at the end of December would definitely be deemed a wash sale.
3. The rules are triggered when you buy “substantially identical securities” before or after the loss. Let’s say you’re selling at a loss the stock in the company you work for but believe strongly that its price will rebound. You’re stuck with the wash-sale time limits once you sell it, and you also need to follow the insider-trading rules even before you do. You could instead buy the stock of another company in the same industry or in a mutual fund or ETF tracking that industry.
4. The wash-sale rules do not directly apply when the sale and purchase both occur in your 401(k) or IRA, as capital gains and losses are not tracked in those accounts. However, after the sale in your retail brokerage account, you cannot outfox the IRS by instead purchasing the same security in your IRA or 401(k). IRS Revenue Ruling 2008-5 goes even further: it prevents you from adding this loss to the basis of the shares purchased in your IRA. That would permanently eliminate the capital loss disallowed in the year of sale.
5. Trades involving listed options, employee stock option exercises, and shares bought through employee stock purchase plans (ESPP) can trigger the wash sale when they occur within 30 days after you sell the stock at a loss. The treatment for incentive stock options (ISOs) is more draconian still, as a wash-sale loss is triggered even when you sell the ISO stock at a price higher than the exercise price but lower than the market price on the date of exercise. For restricted stock or restricted stock units, the grant itself or its vesting may also trigger the wash-sale rules when you have sold stock at a loss, as explained by an FAQ at myStockOptions.com, an online educational resource on equity compensation.
6. Your brokerage firm will track and report wash sales by account. It may not do this across different accounts that you (and your spouse) have at the firm and at other brokers. Therefore, you and/or your tax-return preparer must consider trading activity in securities across all the accounts you have.
7. Form 1099-B, which you receive from your broker in time for tax season (usually by Feb. 15), reports all of your stock sales from the prior year. It shows (in Box 1g) the amount of any nondeductible loss stemming from a wash sale involving covered securities (at least for those in the same account). Note that many brokerage firms reformat Form 1099-B into their own substitute statement that has columns labeled the same as the boxes on the IRS form. You still need to report the wash sale on your tax return on Form 8949, even though the loss on those shares will not be immediately recognized, and adjust the tax basis on the replacement shares when you sell them.
More Tax Resources
See IRS Publication 550 for the IRS guidance on wash sales. It appears in the subsection “Capital Gains & Losses” of Chapter 4 (pages 56–57 in the version for 2021 tax returns).
When your tax planning (and your tax return) for 2022 involves income from company stock sales and/or equity compensation, such as stock options, restricted stock units, or ESPPs, you may want to explore the Tax Center at myStockOptions.com. It has articles, FAQs, videos, and annotated IRS forms that demystify the complex federal tax rules. On December 1, myStockOptions.com is also holding a webinar on year-end and year-start financial planning and tax strategies for equity comp.