Any specific securities used in the following examples are for demonstrative purposes only and should not be considered a recommendation. Investors should fully research any security before making an investment decision.

The Wash Sale Rule was created under Section 1091 of Title 26 - Internal Revenue Code which is part of the code of Federal Regulations.

The IRS created the wash sale rule to prevent investors from recognizing "artificial" losses by first selling a security for a loss and then repurchasing the same security within a short period of time.

At this point, you may be wondering what constitutes a "short period of time." This "short period of time" describes the window of time in which the wash sale rule is in effect. This window is comprised of 61 days - it starts 30 days prior to the sale, includes the trade date, and comes to a close 30 days after the trade date.

How Do I Identify a Wash Sale?

Since the wash sale rule is designed to prevent investors from making "losing" trades in order to avoid payment of taxes, it's important to know how to identify a potential wash sale. Imagine that on December 3, 2007 an investor purchased 100 GE at the official opening price of $38.20. Ten days later on December 13th, this investor sells the 100 GE at the official opening price of $37.00. Finally, on December 14, 2007 the investor purchases the next lot of 100 GE shares on December 14, 2007 at the official opening price of $37.48. The $1.20 per share ($120.00 total) loss deduction from the initial purchase and sale would not be allowed under the wash sale rule. In fact, this loss would be figured into the total cost of the shares purchased on December 14th.

How Does a Wash Sale Affect Me?

As previously stated, if an investor sells a security at a loss and then repurchases a substantially identical security within the 61 day wash sale window, the loss is deferred until the replacement shares are sold.

Let's refer back to the example where the investor purchased 100 GE on December 3, 2007 at $38.20 and then sold the 100 GE shares on December 13, 2007 at $37.00.

Since the $120.00 loss would not be allowed under the wash sale rule, that loss would be added to the cost basis of the next lot of GE purchased.

The aforementioned investor purchased the next lot of 100 GE shares on December 14, 2007 at the official opening price of $37.48. Normally, the cost basis would be delineated by multiplying the share amount by the per share cost:

100 GE x $37.48 = $3748.00 cost basis (or $37.48 per share cost basis)

Since there was a $120.00 loss from the sale on December 13, 2007 the cost basis would be delineated as such:

100 GE x $37.48 = $3748.00 cost basis

$3748.00 + $120.00 loss = $3868.00 cost basis (or $38.68 per share cost basis)

As you can see, the pro-rata loss has been added to the cost basis of the replacement shares purchased. Additionally, the holding period of the replacement GE shares purchased included the holding period of the original GE shares purchased.

In the end, the deferred loss will be "recognized" when the replacement shares are sold.

What is a "Substantially Identical Security"?

Have you ever heard the idiom "It's like comparing apples and oranges?" The idiom evokes the apparent differences between items which are popularly thought to be incomparable or incommensurable, such as apples and oranges.

As a general rule, securities of one corporation are not considered substantially identical to the securities of an unrelated company. For example, General Electric stock is not substantially identically identical to Google stock. Substantially identical securities is more of an "apples to apples" comparison - selling General Electric stock and then repurchasing General Electric stock would be an example of a transaction involving substantially identical securities.

Be aware that there are certain grey areas when talking about substantially identical securities. For example, in cases of a reorganization where one company acquires another, the securities of the predecessor and successor corporations may be substantially identical. Similarly, bonds and preferred stock of a corporation that are convertible into the common stock of the same corporation may also be considered substantially identical as well.

How Do I Avoid a Wash Sale?

Given that the wash sale window is comprised of 61 days, there may be some market risk in planning your transactions expressly to avoid the wash sale.

The most common way to avoid the wash sale is to wait until the wash sale window has closed before repurchasing the replacement shares. Since the wash sale window extends 30 days past the date when the sale occurred, this would mean waiting 31 days after the trade date. The risk here is obvious - in the course of 31 days, a stock's price could rise significantly meaning that you may be paying a higher price to repurchase shares.

Occasionally, certain securities may have the tendency to mirror another, different security. You may be able to reduce your risk of missing out on a gain by repurchasing the securities of a company that move in tandem with your wash sale eligible security. There is not a threat of a wash sale adjustment in this instance since the securities are not substantially identical securities. Plus, 31 days after the sale date of the wash sale eligible security, you may repurchase your original stock if that's your wish. The downside of this situation - there's no guarantee that any two securities will always move in tandem and with the same vicissitude.

Planning for the wash sale rule is, at best, a double-edged blade. Ultimately, there are no riskless ways to avoid the wash sale rule. On the other hand, holding onto a poorly performing stock involves a lot of market risk as well. In the end, it's up to an investor to evaluate all the market risks involved against the benefits of being able to claim a loss on your tax forms!

Wash Sales and IRAs

The most common question asked about the relationship between wash sales and IRAs is this: "What if I sell a security at a loss in my brokerage account and then repurchase the same security in my IRA account while the wash sale window is in effect - will the wash sale come into play since these are two different account with two different tax structures?"

Most investors who ask this question realize that if they repurchase the securities that they sold at a loss in the brokerage account, under the wash sale rule they would not be allowed to deduct the loss. These investors recognize that if the stock was repurchased in an IRA, they may be able to avoid the wash sale rule and place themselves in a "win - win" situation - they are able to deduct the loss from their brokerage account while still continuing their investment in the aforementioned security in their IRA.

If something appears to be too good to be true, it usually is!

The IRS has addressed this controversy in Revenue Ruling 2008 - 05. The IRS Revenue Ruling 2008 - 05 used the example of A who owns 100 shares of X Company stock at a cost basis of $1,000. On December 20, 2007, A sells the 100 shares of X Company for $600.

On December 21, 2007, A causes an IRA or Roth IRA established for the exclusive benefit of him or his beneficiaries to purchase 100 shares of the same company stock at its current fair market value. Since A made the transaction the next day, it came well before the 30 days before or after a sale that the IRS requires if A wants to claim the loss on his taxes.

In the end, the IRS takes the official position that A will not be able to deduct the loss that he realized in the brokerage account. In fact, A can't adjust the basis of any other shares that A owns in his personal account, nor is A able to adjust the basis in the shares that were purchased in A's IRA.

To see the complete IRS Revenue Ruling 2008 - 05 document, please visit http://www.irs.gov/pub/irs-drop/rr-08-05.pdf

Wash Sales and Active Traders

In the world of the IRS, there is a distinction between an "investor" and a "trader." A "trader" in the tax world is different than what a "trader" is in common vernacular. Hence you may be a trader in the usual sense of that word without being a trader for tax purposes.

The IRS is vague when it comes to defining exactly what is entailed in being a "trader" in the tax world. In IRS Publication 550, two specific items are cited:

• You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation. Your activity must be substantial, and you must carry on the activity with continuity and regularity.

• You must pursue the activity of trading in securities to produce income for a livelihood.

Bottom-line, if the nature of your trading activities does not qualify as a business, you are considered an "investor," and not a "trader." It does not matter whether you call yourself a trader or a "day trader."

The tax treatment of sales of securities held in connection with a trading business depends on whether a trader has previously made an election under Section 475(f) of the Internal Revenue Code to use the "Mark-to-Market" method of accounting. If a trader makes the mark-to-market election, all your trading gains and losses will be treated as ordinary income and not capital gains.

Any security that the trader holds at the end of the year is "marked to market." This means that the trader will report gain or loss (on Form 1040, Schedule C) as if the trader sold it at the close of business on the last trading day of the year for its fair market value. All of the gains and losses are reported at the end of the year even if the securities were not sold! Due to this fact, the wash sale does not apply to traders.

If a person does not fall into the IRS definition of "trader" and they have not made the "mark-to-market" election under Section 475(f) of the Internal Revenue Code, they are an investor that must report gains/losses on Form 1040, Schedule D.

One word of warning about being a trader in the tax world - once a trader makes the election under Section 475(f) of the Internal Revenue Code, this designation cannot be revoked unless approved to do so by the IRS!

Jessie Lichter
Team Lead, National Service Center Broker