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Tax Man: How does the IRS 'wash sale' rule work – and does it apply to cryptocurrency losses?

Stocks rise. Stocks go down. While they have risen for the most part so far this year, bull markets won't last forever. And the price of a particular stock can fluctuate across the lot regardless of the general trendline.

If you make an unfortunate stock investment in a taxable brokerage company account, the salvation is that you can claim a tax-saving capital loss deduction (within limits) on the sale. To the right? Not necessarily. In fact, the dreaded Laundry Selling Rule may ban your tax savings.

Here's the story of how the wash sale rule works, including whether it applies to cryptocurrency losses.

This is how the IRS 'wash sale' rule works

A loss on the sale of stocks or mutual fund shares is not recognized for federal income tax purposes if you purchase substantially identical securities within the 61 day period beginning 30 days prior to the loss sale date and ending 30 days after that date. The theory states that selling at a loss and buying essentially identical securities in the opposite direction within the 61-day period constitute an economic "wash". Therefore, you are not entitled to any loss allowance and the tax savings that would normally result from the sale of a loss are not allowed.

If you have an improper wash sale loss, the loss does not simply evaporate (unless your IRA or controlled entity acquires the essentially identical securities, as explained later). Instead, the general rule that the unrecognized loss is added to the tax base of the substantially identical securities that triggered the wash sale rule applies. When you eventually sell these essentially identical securities, the extra foundation will reduce your tax profit or increase your tax loss. In effect, the unrecognized loss becomes a deferred loss that is accounted for when you sell the essentially identical securities.

Example: You purchased 1,000 Beta Bank shares for $ 20,000 on 7/21 using your taxable brokerage account. The stocks collapse. As a tax-savvy person (at least you thought so), you will reap a capital loss of $ 8,000 by cashing out the shares on 12/15/21 for $ 12,000 ($ 20,000 – $ 12,000 sales = $ 8,000 loss). They intend to use this loss to protect an equal amount of capital gains in 2021. After bagging the tax-saving loss (or so you thought), on 12/19/21 you buy back 1,000 beta shares for $ 12,200 because you still like the stock. Unfortunately, the wash sale rule prohibits your expected capital loss deduction of $ 8,000. The unrecognized loss adds to the tax base for the essentially identical securities – the beta stocks that you found on 12/21. Acquire – to $ 20,200 (cost $ 12,200 + $ 8,000 unauthorized loss on laundry sale).

Two strategies to get around the laundry sale rule

Avoiding the wash sale rule is only a problem if you want to sell a stock or security in order to make a tax-saving capital loss, but still want to own the stock or security because you believe it's current price will get off.

One way to get around the laundry rule is the "double-up" strategy. You buy the same number of shares of the stock that you want to sell at a loss. Then wait 31 days to sell the original batch of shares. In the end, you have completed your tax-saving loss sale, but still own the same number of shares as before and can therefore still benefit from the expected increase in value.

Example: You want to sell the 1,000 shares of Zeta you currently own for a 2021 tax savings loss. But you don't want to give up the stock. On 11/21 so buy 1,000 more Zeta shares. Then you can return the original batch of 1,000 shares at any time between December 22nd and December 31st. sell for your tax loss. The washing sale rule is avoided because the 22.12. more than 30 days after 11/21 lies.

There can be a much cheaper way to accomplish essentially the same goal. Try buying a cheap call option on the stock you want to sell for a tax loss in 2021. Then wait more than 30 days to sell the stock.

Example: You currently have 1,000 Yazoo shares that you plan to sell before the end of the year for a tax-saving capital loss in 2021. But you don't want to give up the stock. It could cost as little as $ 100 to buy a call option in January 2022 for 1,000 Yazoo shares, while buying 1,000 actual shares could cost $ 10,000 or more. For example, suppose you buy on 11/21. a call option for 1,000 shares. You can redeem your 1,000 Yazoo shares that you currently own at any time between December 22nd and December 31st. and claim a tax-saving capital loss on your 2021 return because you have successfully avoided the wash-sale rule. Wait at least 31 days before selling the Yazoo shares as the call option and the share are considered to be essentially identical securities for the purposes of the wash sale rule.

Deadline warning: To use any of these strategies you must take action on or before 11/30/21 to have enough time to make a losing sale in 2021 without triggering the wash sale rule.

IRS says the wash sale rule applies if your IRA is purchasing essentially identical securities

For example, let's say you use your traditional IRA or Roth IRA to purchase essentially identical securities on your taxable brokerage account within 30 days of or after a loss sale. Does that trigger the laundry sale rule? According to the IRS (in Revenue Ruling 2008-5), using the IRA to purchase essentially identical securities actually triggers the wash sale rule. Worse, the IRS says you cannot add to your IRA's tax base for the improper loss. The unacceptable loss just goes up in smoke.

Suppose you sell shares at a loss and your spouse buys identical shares within the prohibited 61-day period? The laundry sale rule would clearly apply when filing together. According to IRS Publication 550, the laundry sale rule applies even if you and your spouse file separate returns.

According to IRS Publication 550, the wash sale rule also applies when essentially identical securities are purchased from a company you control.

Cryptocurrency losses are apparently (for now) exempt from the laundry sale rule

Since the IRS classifies cryptocurrencies as "property" rather than securities, the wash sale rule does not appear to apply if you are selling a cryptocurrency holding at a loss and buying the same cryptocurrency shortly before or after the losing sale. Depending on the holding period, you only have a short-term or long-term loss of capital for the garden variety. Don't worry about the laundry sale rule. This favorable government income tax treatment is in line with the longstanding foreign currency loss treatment established by IRS Revenue Ruling 74-218. This is a good thing because some people are actively trading cryptocurrencies and prices can be volatile. Losses are not uncommon and you want to be able to legitimately claim any losses for tax saving results.

Example: You bought a cryptocurrency that was held high and sold it low for a loss of $ 35,000. You have also seen large stock gains in your taxable brokerage account during the year. You can offset a portion of your stock profits with the loss of $ 35,000 on the unfortunate cryptocurrency investment, even if you buy back in the same cryptocurrency shortly after the losing sale. Reason: Cryptocurrency losses are exempt from the laundry sale rule. At least for now.

Losses on crypto-related securities such as Coinbase Global Inc. stocks
COIN,
-1.02%,
may fall under the wash sale rule as the rule applies to losses on assets classified as securities for federal income tax purposes. Cryptocurrencies themselves will not be classified as securities for the time being.

The bottom line

As the year ends, taking advantage of tax losses becomes a popular pastime. However, if you want to get the expected tax savings, keep the laundry sale rule in mind.

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