'Wash Sale' is explained in detail and with examples in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
The Wash Sale refers to an IRS Internal Revenue Service code rule that outlaws any taxpayers from utilizing loss sales on securities in what they cleverly call a “wash sale.” The rule essentially explains such a sale as any that occurs as the investor trades or sells securities at a loss within 30 days before or after this particular sale, buying a stock or other security that is deemed to be substantially identical, or otherwise obtaining an option to do the same. Such a sale will also occur when investors sell the security and their spouse or a company which they own subsequently purchases the same or substantially the same security back.
Where stocks are concerned at least, one company stock and another is never considered to be substantially the same to the IRS. They also do not count preferred stocks or bonds of one company and another as materially the same. Yet there are cases where the preferred and common stocks of a single company could be considered to be basically the same investment. This is especially true when the preferred stock can be freely converted into the company’s common stock with no restrictions, or if they both possess voting rights, and if they trade for a price that is near the official conversion ratio of the preferred stock issue.
When such a loss becomes disavowed by the IRS thanks to the wash sale rule, it means that the taxpayer investor will be forced to add his loss back on to the cost of the newer stock. This would then be known as the cost basis on the new stock. Consider an example to help demystify what is at best a confusing topic. An investor might buy 100 shares of JP Morgan common stock at$35 per share, then sell them for $30 per share in a loss, and in less than 30 days later purchase another 100 shares of JPM common stock for $33. The $500 ultimate loss in this scenario would not be permitted for claiming by the IRS thanks to the wash sale rule. Yet it can be added back in to the $3,300 cost of the newer shares. The basis for the new cost then would be $3,800 as the 100 shares times $33 equals $3,300 plus the $500 loss on the prior trade equates to a total new cost basis position of $3,800.
In truth, the only silver lining to a stock or mutual fund trade that goes bad is that the capital loss can help to offset other more profitable investments elsewhere.
The ironic part is that there is no such wash rule for any investor who cashes out on profits on a trade then reenters the trade within 30 days. Tax professionals call this unfair scenario the “heads I win, tails you lose” IRS is the master rule. Options are similarly included under the wash rules which mean that you can also have your options loss disavowed if you repurchase the identical ones within 30 days.
Many investors will wonder where the IRS draws the lines on the ever popular newer index mutual funds such as the S&P 500 ones. The IRS throws sand in the eyes of the investor by stating that all circumstances have to be considered when evaluating if securities are in fact substantially identical. No one knows what this really means in point of fact. The general interpretation though is that no two mutual funds are “substantially the same” to each other. Yet selling a single S&P 500 index fund for a loss then purchasing another different S&P 500 index fund in 30 days or less would likely be disavowed by the tricky rule.