Tax Guy: How does the IRS ‘wash sale’ rule work — and does it apply to cryptocurrency losses?

Stocks go up. Stocks go down. While they have mostly gone up so far this year, bull markets don’t last forever. And the price of a particular stock can fluctuate all over the lot regardless of the overall trend line.

When you make what turns out to be an ill-fated stock investment in a taxable brokerage firm account, the saving grace is that you can claim a tax-saving capital loss deduction (within limits) when you sell. Right? Not necessarily. In fact, the dreaded wash sale rule can disallow your tax savings.

Here’s the story on how the wash sale rule works, including the question of whether it applies to cryptocurrency losses.

How the IRS ‘wash sale’ rule works

A loss from selling stock or mutual fund shares is disallowed for federal income tax purposes if, within the 61-day period beginning 30 days before the date of the loss sale and ending 30 days after that date, you buy substantially identical securities. The theory is that the loss sale and the offsetting purchase of substantially identical securities within the 61-day period amount to an economic “wash.” Therefore, you’re not entitled to any loss deduction, and the tax savings that would ordinarily result from the loss sale are disallowed.

When you have a disallowed wash sale loss, the loss doesn’t just vaporize (except when your IRA or controlled corporation acquires the substantially identical securities, as explained later). Instead, the general rule is that the disallowed loss is added to the tax basis of the substantially identical securities that triggered the wash sale rule. Then when you eventually sell those substantially identical securities, the extra basis reduces your tax gain or increases your tax loss. In effect, the disallowed loss becomes a deferred loss that is taken into account when you sell the substantially identical securities.

Example: You bought 1,000 Beta Bank shares on 7/1/21 for $20,000 using your taxable brokerage firm account. The shares plummet. Being a tax-smart person (or so you thought), you harvest an $8,000 capital loss by bailing out of the shares on 12/15/21 for $12,000 ($20,000 basis – $12,000 sales proceeds = $8,000 loss). You intend to use that loss to shelter an equal amount of 2021 capital gains. Having bagged the tax-saving loss (or so you thought), you then reacquire 1,000 Beta shares on 12/19/21 for $12,200, because you still like the stock. Sadly, the wash sale rule disallows your anticipated $8,000 capital loss deduction. The disallowed loss increases the tax basis of the substantially identical securities — the Beta shares you acquire on 12/21/21 — to $20,200 ($12,200 cost + $8,000 disallowed wash sale loss).

Two strategies for defeating the wash sale rule

Avoiding the wash sale rule is only an issue when you want to sell a stock or security to harvest a tax-saving capital loss, but still want to own the stock or security because you think it will appreciate from the current price.

One way to defeat the wash sale rule is with the “double up” strategy. You buy the same number of shares in the stock you want to sell for a loss. Then you wait 31 days to sell the original batch of shares. When all is said and done, you’ve made your tax-saving loss sale, but you still own the same number of shares as before and can therefore still benefit from the anticipated appreciation.

Example: You want to sell the 1,000 Zeta shares that you currently own for a 2021 tax-saving loss. But you don’t want to give up on the stock. So, on 11/21, you buy 1,000 more Zeta shares. Then you can sell the original batch of 1,000 shares for your tax-saving loss anytime between 12/22 and 12/31. The wash sale rule is avoided because 12/22 is more than 30 days after 11/21.

There may be a much-less-expensive way to achieve essentially the same goal. Try to buy a cheap call option on the stock you want to sell for a 2021 tax loss. Then wait more than 30 days to sell the stock.

Example: You currently own 1,000 Yazoo shares that you want to sell before year-end to harvest a tax-saving 2021 capital loss. But you don’t want to give up on the stock. It might only cost $100 to buy a January 2022 call option for 1,000 Yazoo shares, while buying 1,000 actual shares might cost $10,000 or more. Say you buy a call option for 1,000 shares on 11/21. You can sell your 1,000 Yazoo shares that you currently own anytime between 12/22 and 12/31 and claim a tax-saving capital loss on your 2021 return, because you successfully avoided the wash sale rule. Make sure to wait at least 31 days before selling the Yazoo shares, because the call option and the stock are considered substantially identical securities for purposes of the wash sale rule.

Deadline alert: To use either of these strategies you must take action on or before 11/30/21 to have enough time to make a 2021 loss sale without triggering the wash sale rule.

IRS says wash sale rule applies when your IRA acquires substantially identical securities

Say you use your traditional IRA or Roth IRA to buy substantially identical securities within 30 days before or after a loss sale in your taxable brokerage account. Does that trigger the wash sale rule? According to the IRS (in Revenue Ruling 2008-5), using the IRA to buy substantially identical securities does indeed trigger the wash sale rule. Even worse, the IRS says you can’t increase the tax basis of your IRA by the disallowed loss. The disallowed loss simply goes up in smoke.

Say you sell stock for a loss, and your spouse buys identical stock within the forbidden 61-day period? The wash sale rule would clearly apply if you file jointly. IRS Publication 550 says the wash sale rule applies even if you and your spouse file separate returns.

According to IRS Publication 550, the wash sale rule also applies when substantially identical securities are purchased by a corporation that you control.

Cryptocurrency losses are apparently exempt from wash sale rule (for now)

Because the IRS classifies cryptocurrencies as “property” rather than securities, the wash sale rule apparently does not apply if you sell a cryptocurrency holding for a loss and acquire the same cryptocurrency shortly before or after the loss sale. You just have a garden-variety short-term or long-term capital loss depending on your holding period. No wash sale rule worries. This favorable federal income tax treatment is consistent with the longstanding treatment of foreign currency losses, established by IRS Revenue Ruling 74-218. That’s a good thing, because some folks actively trade cryptocurrencies, and prices can be volatile. Losses are not unusual, and you want to be able to rightfully claim any losses for tax-saving results.

Example: You bought a cryptocurrency holding high and sold it low for a $35,000 loss. During the year, you also rang up big stock gains in your taxable brokerage firm account. You can offset some of your stock gains with the $35,000 loss from the ill-fated cryptocurrency investment even if you buy back into the same cryptocurrency shortly after the loss sale. Reason: cryptocurrency losses are exempt from the wash sale rule. At least for now.

However, losses from crypto-related securities, such as Coinbase Global Inc. stock
can fall under the wash sale rule, because the rule applies to losses from assets classified as securities for federal income tax purposes. For now, cryptocurrencies themselves are not classified as securities.

The bottom line

As the year-end approaches, harvesting tax losses becomes a popular pastime. But mind the wash sale rule if you want to reap the expected tax savings.

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