Due to the recent stock market (insert your own adjective here…crash, blip, downturn, correction, buying opportunity, etc.), many of you may be holding stocks that you really like from a fundamental standpoint, but that are now worth less than what you initially paid for them. What to do?

Then, all of a sudden your brain crosses a red and black wire, and a flash appears. You say to yourself, "Self, I'll just sell these shares, take the loss on my tax return, and then immediately buy those shares back. I'll then be able to keep the stock that I really like and take a tax loss all at the same time. Sweet."

My advice: Don't do it unless you know the rules. You might run afoul of the wash sale rules. "What?" you may say. You're not beating your shirts against a rock here, you're selling stock. And while that very well may be true, Uncle Sammy doesn't see the humor in the fact that you are retaining your economic position in your stock, but have bought yourself a tax deduction with no risk to you in the future. Therefore, in order to close this glaring loophole, the Feds long ago named this transaction a "wash sale" and deemed that any loss on a wash sale could not be currently recognized.

Under the wash sale rules if you sell stock for a loss and buy it back within the 30-day period before or after the loss sale date, the loss cannot be claimed for tax purposes.

This rule is designed to prevent taxpayers from selling stock to claim the loss while buying it back within a short period of time to retain ownership. Note that the rule applies to a 30-day period before or after the sale date to prevent "buying the stock back" before it's even sold.

Although the loss can't be claimed on a wash sale, the disallowed amount is added to the cost of the new stock. This being the case, the loss can be claimed when it is finally disposed of other than in a wash sale.

Example #1: Larry Laundry buys 500 shares of ABC Corp. for $10,000 and sells them on June 5 for $3,000. On June 30, he buys 500 shares of ABC again for $3,200. Since the stock was "bought back" within 30 days of sale, the wash sale rules apply. Larry can't claim his $7,000 loss. Instead, he must adjust his basis in the repurchased shares. His basis in his "new" 500 shares is $10,200: the actual cost plus the $7,000 disallowed loss.

Larry would also be in violation of the wash sale rules if he had purchased his "new" shares on June 1 and then made the loss sale on June 5. Remember: the rule is 30 days before OR after the date of the loss sale. But remember also that if Larry had waited the required 30 days before he "repurchased" his shares, there would be no wash sale.

But how about if you repurchase fewer shares than you originally sold for a loss? Is all of the loss disallowed? Nope. Only that portion of the loss attributable to the "washed" shares will be subject to disallowance. In short: if only a portion of the stock sold is bought back, then only that portion of the loss is disallowed. Thus, in the above example, if Larry had only bought back 300 of the 500 shares (60%), he would be able to claim 40% of the loss on the sale ($2,800 under the facts above). The remaining $4,200 of loss disallowed under the wash sale rules would be added to Larry's cost of the 300 shares, and Larry's basis in the new shares would be $7,400.

As you can see, if you're doing a bunch of trading in a specific stock (not very Foolish, by the way), the wash sale rules can really jump up and complicate your life. Buying and selling, different numbers of shares, different prices, gains, and losses, basis adjustments, yada, yada, yada. Whew… way too much work for many people.

But, and this is a very big "but," the wash sale rules really become moot if you close out your entire position in the stock prior to the end of the year… and then stay out of the stock for the required 30-day period before or after the date of the loss sale.

Let's look at Larry again. He certainly has a wash sale in Example #1. But let's say that Larry tires of his position in ABC company and sells his 500 shares on December 20 for $4,000. Larry's adjusted basis in the shares is $10,200 based upon his wash sale computations and his overall loss would amount to $6,200. But if you break down the two separate "buy" and "sell" transactions, you see that Larry generated a loss of $7,000 on the first transaction, and a gain of $800 on the second transaction -- amounting to a ''net" loss of $6,200. This, amazingly, is the same amount of loss Larry computes when taking the wash sale and basis adjustment rules into account. So, since Larry closed out his entire position in the shares prior to the end of the year (and stayed out of the stock for the required period), the wash sale transactions actually become meaningless, and Larry can compute his gains and losses as he regularly would.

So, remember: the wash sale rules really only apply when the transactions bridge two tax years. You can trade all you want throughout the year, but if you close out your position prior to the end of the tax year and stay out for the required period of time, the wash sale issues are really not important. But if you hold on to just one little share into the new tax year, you can look forward to making a bunch of wash sale computations.

One final note: while the wash sale provisions work on shares that you sell for a loss, there are no corresponding provisions for stock that you sell at a gain and then immediately repurchase. So, while wash sale losses can't be claimed, gains can't be avoided. That is, if you sell stock for a gain and buy it right back, you must still report the gain -- no special gain deferral rule applies.

If you would like to read more about the wash sale rules, check out IRS Publication 550 at the IRS website. As for me, I've got a load of dirty clothes to tend to.

- 09/11/98

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