When there's a stock market ____ (insert your own descriptor: crash, blip, hiccup, tragedy, correction, buying opportunity, etc.), many of you may find yourselves holding stocks that you like from a fundamental standpoint, but that are now worth less than what you 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 be able to keep the stock 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. Uncle Sammy doesn't see the humor in the fact that you're retaining your economic position in your stock while getting yourself a tax deduction. Therefore, 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.

Wash Sales Explained
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 immediately claimed for tax purposes.

This might sound outrageously unfair to you. After all, if your money was plunked into the stock, and your dollars were lost, how can it be that you're not allowed to claim the loss?

You do get to claim the loss -- just not now. Although the loss can't be claimed on a wash sale, the disallowed amount is added to the cost of the repurchased stock. So, the loss can be claimed when it is finally disposed of, other than in a wash sale.

Example: 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 for $3,200. Since the stock was repurchased within 30 days of loss-sale date, 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 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 also remember that if Larry had waited the required 30 days before he purchased another 500 shares, there would be no wash sale.

Buy Fewer Shares
What if you repurchase fewer shares than you originally sold for a loss? Is all of the loss disallowed? Nope. Only the portion of the loss attributable to the "washed" shares will be disallowed.

Thus, in the above example, if Larry only bought back 300 of the 500 shares (60%), he would be able to claim 40% of the loss on the sale ($2,800). The remaining $4,200 of the 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 $6,120 (the cost of the original 300 shares of $1,920 plus the disallowed loss of $4,200).

Burning Bridges
But, and this is a very big "but," the wash-sale rules don't apply 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 the example above. But let's say that Larry tires of his position in ABC Co. and sells his 500 shares on Dec. 20 of the same year for $4,000. Larry's adjusted basis in the shares is $10,200 based on 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 30-day period), the wash-sale transactions actually become meaningless, and Larry can compute his gains and losses as he regularly would.

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 entire gain -- no special gain deferral rule applies.

For the word straight from the horse's mouth, read IRS Publication 550.

Tax Issues for "Traders" - Part I
Worthless Stock
The Constructive Sale Rules - Part I
IRS Publication 550

If you like the way Roy Lewis simplifies confusing tax issues, check out his just-published book, The Motley Fool's Investment Tax Guide 2002: Smart Tax Strategies for Investors. This handy 360+ page guide covers just about every tax aspect of a typical Fool's life: investing, marriage, children, education, homes, home offices, retirement accounts, medical expenses, and much more.)

October 18, 2002

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