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Wash Sales Could Take You to the Tax LaundryTax law allows you as an investor to offset capital gains with capital losses, and if the losses exceed the gains, you can deduct losses up to a maximum of $3,000 ($1,500 if filing married separate) for the tax year. For this reason, investors frequently review their securities portfolio at year's end searching for stocks and other securities whose sales will result in a capital loss. This allows them to minimize their gains or maximize their losses for the year.
The wash sale rules could spoil this planning strategy, however. Under these rules, a loss is disallowed if the security sold at a loss is repurchased within 30 days. A loss will also be disallowed if the investor buys the same security 30 days before the sale. The IRS definition of a wash sale is: "A sale that occurs when you sell or otherwise dispose of stock or securities at a loss, and within 30 days before or after the sale or disposition, you buy substantially identical stock or securities."
This rule can affect the investor who may actually wish to hold a particular security, but only sells to take advantage of a loss position intending to buy the same security back at a later date. It can also affect "day traders" who buy and sell the same security frequently during the year.
When wash sales do occur, the tax basis of the replacement stock is increased by the amount of the loss that was disallowed, so when you sell the replacement stock you will be able to take advantage of losses incurred in the wash sale.