Wash Sale Rules Keeping Short Term Capital Losses Deductible

One of the worst surprises an investor can get is a big tax bill at the end of the year. A big hit from capital gains taxes can turn an otherwise very profitable investing year into one that is only marginally profitable, or even worse, can turn a year of positive returns into an overall loss for the year. Avoiding this unpleasant event takes year-round tax planning. Unfortunately, however, creating a tax problem can take just one mistake.

Short-Term Capital Losses Deduction - Offsetting Capital Gains

Most investors are aware that they have to pay taxes on the profits that they generate while trading securities such as stock, bonds, ETFs, and mutual funds.

These taxes are divided into two major categories: Short-Term Capital Gains and Long-Term Capital Gains.

Long-term gains benefit from a reduced tax rate that encourages longer term investing. Short-term gains, however, are fully taxed at the investor's nominal tax rate. The difference can be substantial depending upon the investors tax bracket and where the taxpayer's income comes from overall.

The long-term capital gains tax rate is just 15% for most investors, although certain investors with lower incomes can benefit from an even lower long-term capital gains rate. Many successful investors are in the 30% or 35% tax brackets. This means that the difference in taxes for a short-term gain and a long-term gain can be as much as 20% more taxes for short-term capital gains.

Avoiding these much higher income taxes is why investors look so hard to generate short-term capital losses whenever possible to offset short-term gains, particularly near the end of the tax year. However, going about generating a capital loss in the wrong manner can actually ruin the ability to deduct the loss.

What Is a Wash Sale? IRS Wash Sale Rules

A wash sale occurs when the investor sells a security and then repurchases the same, or substantially similar, security within 30 days. In other words, if a taxpayer sells 1,000 shares of IBM stock on November 10th and then repurchases 1,000 shares of IBM stock on November 25th, a wash sale has occurred.

The problem with a wash sale is that if it generates a capital loss, whether a short-term loss, or a long-term investing loss, that loss cannot be used as a tax deduction. More specifically, the loss from a wash sale cannot be used to offset capital gains in the investor's portfolio.

While IRS wash sale rules apply to both short-term capital losses and long-term capital losses, they can be particularly devastating to taxpayers hoping to avoid short-term capital gains taxes.

Avoiding Wash Sales To Save Money On Taxes for Investors

Wash sales occur only when the same, or substantially similar, securities are sold and repurchased. The rules about what constitutes a similar security are complex, but do eliminate the ability to use proxies or other stand in investments such as stock options to get around wash sale rules. However, that does not mean that a savvy investor has no options when it comes to generating short-term investing losses that are usable for tax saving purposes.

When it comes to securities like exchange traded funds, or ETFs, or mutual funds, investors often have other investments that can be purchased that would not trigger the similarity features of wash sales. For example, an investor looking to generate a short-term capital loss to offset short-term capital gains could sell 1,000 shares of a S&P500 Index ETF at a loss to generate the short-term loss desired. The investor could immediately purchase an equal dollar amount of shares in a S&P100 Index ETF or a S&P1000 Index ETF.

While these investments are not the same (which is the whole point) over a 30-day period, such investments could be reasonably expected to perform in a very similar manner to the original investment in the S&P 500 Index. After the 30 day wash sale period is up, the investor could sell the replacement ETF and repurchase the original ETF investment without fear of triggering wash sale rules.

In this way, an investor can generate money saving short-term investing losses without creating wash sales that can cause long lasting tax headaches.