The IRS 30-day wash sale rule explained

The IRS has a rule that if you sell a stock for a loss and buy it back in less than thirty days they consider it a "wash sale" and you cannot take the loss on your tax return until you sell it again (and of course not buy it back within 30 days). This prevents portfolio churning and creation of a fake "loss". The rule is a bit confusing so I have decided to try to explain it here.

I will start with an example:

You buy 100 shares of XYC stock for $500. You sell the stock today (September 28, 2009) for $300 (net). You have a loss of $200.

If you do not buy XYC stock again for the next 30 days you can take the loss on your tax return next year. This is the simple part. If you do buy it back in less than 30 days then you cannot take the loss on your tax return. It gets "rolled over" until the next time you sell. I will continue with my example:

You sold the stock as listed above. You decide that this was not a good idea and buy it back for $350 the next day. Now your basis in the stock is $550 (adding in the "washed" loss. Your "buy date" for tax reporting purposes is the original date in which you first bought the stock.

This is where it can get tricky. You actually did lose $200 of your original $500. It is a real loss. The IRS says you have to wait to claim that loss on your taxes until you sell your XYZ stock again without triggering another wash sale.

I should also mention that option contracts on the same stock are considered a wash as well. If you sell stock at a loss and then buy a call option on that stock the IRS rules state that it is still a wash sale since it is a "substantially" similar security. You have to carry forward your loss in this case as well.

Short sales are also included in the wash sale rule. If you sell short, cover the short, and sell short again without 31 days going past then you have the same wash sale as above. Your loss will carry over until you are no longer "washing."

This rule is complicated but of high importance to traders. People can find themselves having the IRS change their tax return if it is violated. I have written my own interpretation of the rule here but for more information check out IRS Publication 550. Please note that I am not a tax advisor and this post does not constitute advice.