The stock trading market is straightforward, but there are many intricate details that a new trader could find confusing. The outline of the stock market involves the use of a broker to buy and sell stocks. The trader aims to sell shares at a higher cost to bank a profit.
The money additionally spent is on fees and brokerage. But in today’s world, a free brokerage account gives the users a chance to make the most of their investments without losing any portion.
Selling stocks is always equated as a profit-making method. No user will willingly sell the shares for a substantial loss unless they are in dire need for money, or want to re-invest the held-up funds.
However, there is another reason to sell these stocks at a loss. One such idea is tax-loss-harvesting.
Tax-loss harvesting is the method by which the investor will sell a small section of their investment at a loss to bring down the total capital gain. In this way, they can save on the tax paid since their average is at a loss.
The advantage of tax loss harvesting is very prominent for long-term investors. This process helps them reduce the burden of tax and sustain their investments. Similarly, the method costs them the transaction fees and will need assistance from financial experts to execute them correctly.
Some companies and individuals can use Robo-advisers to make this task easier. These are innovations in trading technology, such as automated platforms that will help calculator the sales.
One such rule that adds to the complexity is the wash sale rule.
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The Wash Sale Rule.
Wash sales occur when the user sells a stock at a loss to save on taxes. This sale occurs before the time of tax filing.
If a particular security is under a capital loss, then it can be sold at the time of filing taxes. This step lowers your overall capital gain made from the profit of other stocks.
In practice, this sounds like a misuse of the system to gain tax benefits. But the IRS or the Internal Revenue Service has this protected with the help of a wash-sale rule.
If the user sells the securities at a loss and then buys “substantially identical stocks” back within thirty days, their losses are disallowed. This rule can also affect the person if they sell the stock, and a member of the family or their controlling company repurchases this stock. Before we jump into details of this rule, let’s take an example to understand the wash-sale better.
Suppose you have an investment where to buy 50 shares of a company X at $500. After a month’s time (and close to the end of the year), the value of this stock X has reduced to $200. You then sell the whole holding for a capital loss of $300 for a tax deduction.
If, in the next 30 days, you were to repurchase these 50 stocks, the initial loss will no longer count for a tax benefit. This rule is only applicable because the security was restocked within the designated time of 30 days. The same is true if your company or your spouse were to buy these 50 stocks.
This way, the IRS can reduce the misuse of wash-sales and stop investors from leveraging this policy for an uncertain tax benefit.
According to the IRS, bonds and preferred stocks do not count for “substantially identical stock.” This rule is only applicable to common stocks.
‘Preferred stocks’ are the ones that produce a higher dividend and variable asset distribution. These are usually issues to the stakeholders of the company.
However, if the preferred stock is convertible into a common stock, it could be considered a substantially identical stock. Also, if the holders of preferred stock have the same rights as that of a common stockholder, they fall into the same category.
What Happens In Case of a Repurchase?
If the IRS does not recognize the loss because of the wash-sale rule, the loss-amount will be added to the new stock’s purchase cost. Thus the value of the new share will alter. This process must be hard to understand without an example.
Let’s consider; you buy ten shares of Apple $430 a stock. You sell these shares back at the cost of $400. Now, you repurchase these, within a 30 days’ period, at $420.
Because of the wash-sale rule, the tax-benefits from past loss are disallowed. And the loss-amount will add to the cost of the next share purchase. Therefore, instead of paying $4200 for the ten stocks, you will pay $4500 (or $450 a stock).
How To Hold Market Position During the Wait Period?
While this is a great way to cut back on the tax losses, the user could suffer from a lack of market position. This implies that selling the stock could lead to a lack of holdings in the sector or the company.
Rather than spending a higher amount on the repurchase, you can invest in an ETF (exchange-traded fund), bonds, or mutual fund of the same company. At the end of the waiting-period, convert these to securities.
Note: If you sell stocks to portray a loss and the losses are higher than your gains, in that particular financial year — you can carry the damages to the next year. These are called Carry-over-losses.
Final Thoughts
As it is clear from this detailed explanation, the wash-sale-rule does not affect new traders. The rule vividly applies to large investors and long-term traders. If you are looking at active trades, the wash-sale rule places little importance.
If you are new to trading, however, you should be aware of the market’s rules and regulations. This practice will ensure that you do not lose your money to fines and fees. A reliable broker should be able to assist you in case you hit a roadblock.
The only thing to keep in mind is that making use of tax-loss harvesting is a complex process that could take years of financial experience to master. Be sure to consult an expert or use an online automation tool to determine these calculations.