Wash Sale Rule Related to Equity Compensation (RSUs, ESPP, ISOs)
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If you sell an asset for a loss, you can usually take the deduction on your tax returns. However, it can get tricky if you use those funds to buy another asset, especially if you're eligible for multiple forms of equity compensation from your company. For example, if you're eligible for RSU stock and ESPP, you might face the wash sale rule.
Here's what you must know.
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The Wash Sale Rule- What Is a Wash Sale?
If you sell an asset at a loss but buy a substantially identical stock or asset within 30 days of the 'loss,' you can't claim the loss until you sell the replacement stock or asset. Rather than deducting the amount of the loss, you reduce the cost basis of the asset that replaced it by the same amount.
The IRS considers this a postponement of your capital losses. You aren't losing the loss, so to speak. You still get to use it, but only once you sell the securities bought with the money from the loss.
You might sell stock at a loss with equity compensation but then repurchase it with your ESPP. Unfortunately, if it's within 30 days of selling the stock at a loss, you won't be able to take the deduction for the loss quite yet.
Covered vs Uncovered Securities by the Wash Sale Rule
The wash sale rule applies to almost all securities or any security with a CUSIP number, a nine-digit identifier. This includes stocks, ETFs, mutual funds, and options. It also includes any assets acquired and sold as a result of ISOs, RSUs, and ESPP shares.
Cryptocurrency is one of the only assets the wash sale rule doesn't apply to because the IRS doesn't consider it a security. So if you sold a stock at a loss and used the funds to buy cryptocurrency, it wouldn't trigger the wash sale rule. But if you sold a company's stock and repurchased it within 30 days, it would trigger the wash sale rule.
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Selling for a Loss - Tax Loss Harvesting
You might wonder what happens if you take advantage of tax loss harvesting or selling the stock at a loss to offset gains on another security. Tax loss harvesting is a beneficial strategy for many investors and, fortunately, can still work with the wash sale rule. In addition, tax loss harvesting can minimize your tax liabilities on capital gains and be a strategic way to increase your profits.
However, with tax loss harvesting, investors typically buy similar securities after claiming the loss. To avoid a wash sale, they wait 31 days to rebuy the asset. As long as you are outside the 30-day window, you can repurchase the same security or a similar one.
The Wash Sale Rule Related to Equity Compensation
If your company provides equity compensation or ownership in the company after you reach a certain vesting point, the equity compensation is subject to the wash sale rule.
For example, selling your company's stock at a loss and exercising options to buy shares within 30 days of the sale is subject to the wash sale rule. It also applies to receiving vested RSUs, or any assets purchased as a part of an Employee Stock Purchase Plan.
The loss incurred from the sold shares will increase the cost basis of the replacement stock rather than claiming a loss.
Keep in mind this applies no matter how you buy the replacement assets. So, for example, if you sell stocks in one account, and buy them in another, such as a part of your ESPP, the rule still applies.
When a Wash Sale Occurs - Examples
It might help to see an example of how the wash rule sale works.
If you buy 200 shares of ABC stock at $20 a share, you invest $4,000. You keep the stock for six months and then sell it when the price drops. You're worried about losing too much, so you bail.
You sell the stock for $15 a share, taking a loss of $1,000. If you didn't reinvest the funds, you could claim the loss on your current year's tax return. However, two weeks later, you see that ABC stock decreased again, this time to $10 a share. You decide it's a great buy you must take advantage of because you know it will go back up, so you buy ABC stock again.
You, again, bought 200 shares but only invested $2,000 this time. Because you repurchased identical stocks within 30 days, you can no longer take the deduction for the loss. Instead, the 'loss' becomes a part of the new cost basis, bringing your investment up to $3,000 instead of $2,000.
Now when you sell the stock, assuming you don't purchase it again, you'll pay capital gains only on the difference between the selling price and $3,000. So, for example, if you sold the stock in a few months for $4,000, you'd pay capital gains taxes on only $1,000 ($4,000 - $3,000) instead of $2,000 ($4,000 - $2,000).
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Substantially Identical Securities
To understand the wash sale rule, you must understand the definition of 'substantially identical securities.'
For example, two stocks of two different companies are not substantially identical. The same is true of a company's bonds or preferred stock compared to its common stock. However, there is an exception. If a company's preferred stock can convert to common stock, it's considered substantially identical.
Cost Basis Change
When you cannot use the loss from selling a stock because the wash sale rule exists, you must add the loss to the amount paid for the new stock. This increases the new stock's cost basis or the amount it costs you to purchase.
Increasing the cost basis decreases the amount of capital gains taxes you'll pay when you sell the asset outside of the wash sale rule. So while it's frustrating to lose the loss deduction, you decrease the total taxes you'll pay when you eventually sell the asset for good.
Avoid Wash Sale Rule Violations Regarding Equity Compensation
There isn't an actual penalty for violating the wash sale rule. In other words, you won't pay a fine or have legal troubles. However, the IRS will not allow you to deduct the loss if the wash sale rule applies.
So how do you avoid wash sale rule violations? It's not as hard as you think.
Purchase Securities Not 'Substantially' Identical
The first way is to avoid buying substantially identical securities. This could get tricky since the decision on this could be subjective. As a rule, if you aren't sure, ask a tax professional or investment advisor.
The simplest way to avoid violating the wash sale rule is to do nothing for the first 30 days after selling the asset. For example, if you wait 31 days to repurchase an asset, the rule doesn't apply, and you can deduct the loss and enjoy your new capital gains.
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Are There Consequences to Not Adhering to the Wash Sale Rule?
There aren't any hard and fast penalties you'll pay or face for not adhering to the wash sale rule. However, you can guarantee the IRS will catch up to you and will not allow the loss deduction. This can create a complicated situation with your tax filing, so it's best to follow the rule or avoid it if you can.
Does the 30-Day Rule Apply if a New Calendar Year Starts?
Wash sales rules aren't confined to a specific year. It's based on a 30-day period. This means even if you sold a stock on December 29 and rebought it on January 15, the wash sale rule would apply. It's based on 30 calendar days, no matter if there's the start of a new year.
Does the Wash Sale Rule Apply to Cryptocurrency?
Cryptocurrency is one of the only securities that the wash sale rule does not currently apply.
The Bottom Line
The wash sale rule is more of an inconvenience than a financial planning issue. Yes, you can't take the deduction for a loss, but only for a short while. However, when you sell the stock you purchased with the funds from the loss, you pay fewer taxes on your capital gains because of the stepped-up cost basis.
It can get complicated, so it's best to talk to a professional tax advisor about what you can and cannot do to avoid getting yourself in trouble at tax time. For example, buying and selling the same stock can be a smart investment move, but when it comes to taxes, it can complicate things.