Planning to Tax Loss Harvest? BEWARE of the Wash Sale Tax!

One thing that many investors will realize throughout their investing journey is that trading in and out of stocks can be extremely expensive due to the amount of taxes you’ll pay. To try to minimize that impact, they’ll try to tax loss harvest but if you do it incorrectly, you’re going to get crushed with a wash sale tax!

Key Takeaways:

  • If you buy a stock 30 days before/after selling it, a wash sale tax occurs
  • The wash sale tax effectively resets your basis, therefore disallowing any tax-loss harvesting in that timeframe on those shares
  • Buying “substantially identical” funds also will trigger a wash sale, even if it’s a different security
  • Don’t let the tail (taxes) wag the dog (your portfolio)

In this post, I’m going to cover the following topics

What is the Wash Sale Tax?

When you sell a stock and then buy it back within 30 days, a “wash sale” occurs. What this means is that the basis of your stock isn’t reset like it normally would be, but instead it’s adjusted to reflect the original purchase and sale that you made. Let me explain with an example:

If you were to buy 100 shares of company $XYZ for $100/share, that means your cost basis/share would be $100. If the share price then dropped to $80/share and you decided to sell the shares, that means you lost $20/share.

Then, let’s say something comes out that entices you to buy those shares back at $90/share, within 30 days from when you initially sold the shares. This then triggers a wash sale. You effectively will take the $20/share loss that you had from the initial purchase & sale, and then add that to the new cost basis of your shares:

You might be wondering why all of this matters and why you should care, but as you get a little further in your investing journey and try to become a tax-efficient investor, you’ll completely understand the logic! Until then, let me show you a few scenarios to help paint the picture!

Common Scenarios Where the Wash Sale Tax Occurs

The most common scenario that I see with the wash sale tax is when people are trying to take advantage of tax-loss harvesting. Tax-loss harvesting is when you’ll sell some of your investments at a loss to offset some investments that you have sold that you’ve realized gains that year.

It can be an extremely impactful strategy when used correctly, but it’s also imperative that you understand the rules. With tax-loss harvesting, you’re essentially going to sell some of your stocks that have lost money within the last year and then offset those losses with some stocks that have done well for you.

The reason that you would want to do this is that eventually, you’re going to have to pay taxes on those gains if your money is in a taxable account, so you can somewhat trim your tax bill a little bit now instead of eating it all in the future. Let me explain with an example:

You own two stocks, both of which you invested $10K into.

Stock A – this stock has lost 40% in the past year, maybe because you were invested in a risky growth stock, so now you only have $6K invested. You’ve decided that you don’t think this company is a good investment anymore and you want to get out of it.

Stock B – this stock has grown 20% in the past year and is now worth $12K. You like this company, but you think that the valuation might be a little bit stretched.

If you completely sell Stock A then you now have $4K in losses that you would ideally offset with gains. You can sell some of stock B to completely, or partially, offset some of these gains.

The benefit of this is that if you were to sell $2K of Stock B, then you’d be completely offset, and you wouldn’t owe anything on that $2K, while if you didn’t offset the gains, you’d eventually have to pay taxes on all of your gains whenever you sold the stock.

The place where the wash sale tax comes into play here is that you can’t simply sell one of these stocks and then buy it back immediately – you have to wait at least 30 days before repurchasing the shares, so don’t think you’re going to pull a fast one on the IRS.

The other common scenario that I see the wash sale tax occurring is when people think that they can buy a very similar security to be able to avoid the wash sale tax, but that isn’t the case. It turns out that the IRS not only looks for purchases of the same stock but also purchases of securities that are “substantially identical.”

What exactly does “substantially identical” mean? Truthfully, nobody knows because there isn’t a formal definition, but we can likely speculate based on what we would deem as substantially identical.

One obvious example to me would be an S&P 500 ETF. There are tons of options out there like VOO, SPY, IVV, and others, but I would certainly think that if you own SPY and it’s down 10%, then you can’t simply sell all of your holdings and move everything into VOO or IVV because the goal of those ETFs is the same – to mimic the returns of the S&P 500.

If you’re going to try to take advantage of tax-loss harvesting, then you’re going to be much better off just moving those funds into security where there’s no doubt that it can’t be misconstrued as being substantially identical.

How Does a Wash Sale Affect My Taxes?

A wash sale can massively affect your taxes. If you’re experiencing a wash sale tax, it’s likely either because you’re trying to tax-loss harvest or because you’re a trader and trading in and out of the same security quite frequently. Either way, it’s imperative to understand that you’re not going to get any sort of tax benefit for selling that security.

In the previous example that I gave where you sell Stock A and Stock B, if you’re going to go back and buy Stock A again within 60 days, you can’t count any of those losses from your initial sale, so now you’re going to be stuck with paying taxes on your gains from Stock B rather than them offsetting like you initially intended for them to do.

Another major issue with doing this is that if you sold Stock B simply to lock-in some gains but you hadn’t held that stock for over a year, you’re now going to pay ordinary income tax on it rather than long-term capital gains tax which is significantly less, as you can see below from Bankrate:

The best way to think about the impact that a wash sale might have on your taxes is this – you’re going to pay normal taxes despite realizing losses on the security that you bought.

The wash sale tax is something that affected me quite frequently when I was first getting started in my investing journey because I thought that I could be a stock trader.

I won’t lie – I was someone that had Robinhood that would buy and sell stocks based on what the talking heads would say on CNBC. I was blindly buying and selling based on their recommendations and while I could go off forever on how dumb the strategy was, the fact is that I was making foolish mistakes and trading in and out of the same few companies all the time.

At the end of the day, I lost a lot of money doing that but wasn’t able to write it off on my taxes because I was getting hit with the wash sale tax – the worst of both worlds!

Now, eventually, things will catch up and you can write off the tax in a future year, but the issue is that I was trying to get a tax advantage and sell some winners and offset those gains with some losses.

In other words, I completely messed up my tax scenario and it cost me. But guess what, I learned from it and here I am trying to teach you about the potential pitfalls to look out for!

How Can I Avoid Paying a Wash Sale Tax?

The extremely simple answer here is to not let the tail (taxes) wag the dog (your portfolio). This is an analogy that I like because taxes are simply just a part of investing and while there are definite strategies to minimize the amount of taxes that you pay, you need to make sure that you’re keeping your eyes on the prize and worrying about the securities that you hold first and foremost, and the taxes are a secondary piece of that.

I am someone that still partakes in tax-loss harvesting, but I do it in a very safe way. Let me explain my process:

Sometimes at the end of the year, I’m doing some “cleaning” and there are stocks that I no longer want to own. In that case, I am going to cut shares of that company instantly because I don’t believe in the company anymore.

Some other times we might get to the end of the year where I own a company where I have a little bit less conviction on that company and want to trim a little bit. I won’t say the company here, but there was one stock that I owned where I had 500 shares and at my highest purchase price, I lost almost 90% on that investment. This was in one of my extremely risky speculative investments so I knew that there was a chance I could lose a lot of money, but the thesis in this company somewhat changed which was the concerning part to me.

Since with Fidelity, I can sell specific shares, this is what I did. I sold the shares that had a 90% loss on them and kept my remaining 100, therefore accomplishing my goal of some tax-loss harvesting and also trimming a position that I didn’t have as much conviction in.

If I had more conviction in this company, I wouldn’t even think about selling – I’d be adding to it! But that wasn’t exactly the case here.

Truthfully, I think tax-loss harvesting can be a powerful tool, but if you’re selling investments that you want to be in, then you’re just gambling.

Sure, you might think, “I can sell my AAPL shares now for $150 and hope that when I buy them back in 30 days they’re not higher than $150.”

I get the thought here but let’s break this down…if you think a stock is good enough for you to own for a long time, that means it’s going to theoretically go up over time, right? So, that means the odds of it going up in one month are greater than it going down, right?

So, if you do this, you’re once again letting the tax tail wag the dog – stop!

Tax-loss harvesting can be a very powerful tool, typically when you’re rebalancing or moving money from like funds into others, but not those that are identical. If you had to do something like this, I’d recommend buying an ETF specific to the stock you’re selling so you can still capture some of the general sector returns, such as selling FSLY and buying WCLD to capitalize on cloud computing.

Summary

The Wash Sale Tax is something that many people are unaware of when they get hit with it the first time, and sometimes many times after that. You might wonder why there’s a little ‘W’ next to the stock that you own when you log in to your broker but just stop worrying about it once you log out. Well, now you know.

And most importantly, hopefully, you should know some good ways to completely avoid the wash sale tax…the best way? Buy and hold stocks for the long term! And to do that, I recommend the Sather Research eLetter!

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