If you’ve made multiple purchases and sales of stock in the same company (or shares of the same mutual fund) within the same year, you may have been surprised at what was reported on Form 1099-B. This report of the tax consequences of your sales may seem to bear little relationship to the actual activity in your account. If your trading activity includes wash sales, it may be all but impossible for you to determine whether the results reported on this form are correct. From what I’ve seen, there’s a good chance they aren’t.
The wash sale rule is simple enough to be stated in a few words, yet the calculations required to apply the rule are immensely complicated. A full solution to the problem requires a relational database. It’s possible to work through some sequences on a single spreadsheet, but the task can become surprisingly difficult as the number of transactions increases.
The wash sale rule is designed to prevent you from claiming a loss from selling shares that are replaced by substantially identical shares that are acquired about the same time. specifically, if you buy replacement shares during the 61-day period beginning 30 days before and ending 30 days after the date of sale, your loss is disallowed and added to the basis of your replacement shares. In addition, the holding period of the replacement shares is adjusted to include the time you held the shares that were sold at a loss.
That’s it for the basic rule. We’ll ignore some of the thornier issues, such as when shares should be treated as “substantially identical” and circumstances where shares should not be considered replacement shares. The calculations are complicated enough without those issues.
A simple sequence
Suppose you had the following sequence of transactions in the same stock, all occurring within a period of 30 days:
- Buy 50 shares
- Sell these 50 at a loss
- Buy 20 shares
- Sell these 20 shares at a loss
- Buy 100 shares
- Sell 75 of these shares
Transaction 3, a purchase of 20 shares, triggers the wash sale rule as to 20 of the 50 shares sold at a loss in transaction 2. The loss from 20 of those shares is disallowed and added to the basis of the 20 replacement shares. This increase in basis will increase the amount of loss reported on the sale of the 20 replacement shares in transaction 4.
Things get interesting at transaction 5. This purchase triggers the wash sale rule as to 30 of the shares sold in transaction 2, because we previously applied the wash sale rule to 20 of those shares. This purchase also triggers the wash sale rule as to the 20 shares sold in transaction 4.
Notice that in order to analyze this purchase correctly, we had to keep track of not only the number of shares that have been sold at a loss within the wash sale period, but also how many of those shares have previously had their loss disallowed.
At this point — after transaction 5, that is — your investment account holds 100 shares, all acquired in a single purchase, and yet for tax purposes you hold three distinct lots, each with a different holding period and basis. Of these 100 shares, 30 have their basis and holding period adjusted based on the sale in transaction 2, another 20 have their basis and holding period adjusted based on the sale in transaction 4, and the other 50 are not adjusted.
Your sale of 75 of these shares may appear on your brokerage statement as a single transaction, but will likely appear as three sales on Form 1099-B. You sold shares from each of the three lots described in the previous paragraph. Overall you’ve bought and sold shares just three times, but you’ll have five sale transactions listed on the tax form.
Working through the analysis
Although brokers and mutual funds are now reporting basis and holding period for sale transactions (and applying the wash sale rule), you or your tax professional may have to perform these calculations due to gaps in broker reporting or simply because the broker appears to have reported incorrectly. You have to start with a list of transactions, and apply a two-step analysis to each one.
For each purchase, the first step is wash sale analysis. We saw that the third purchase in the example above (transaction 5) had to be divided into three lots, each with different basis and holding period. The second step is to match these lots with sales, which may divide them into smaller increments, because a particular sale transaction may dispose of only part of a lot.
For sales, the order of the two steps is reversed. First you need to match the shares sold with lots owned, which may divide the sale into smaller pieces. The second is wash sale analysis, which may divide those pieces into even smaller increments.
Up to a point you may be able to do these calculations on a one-page spreadsheet. When the volume of transactions makes this solution impracticable, specialized software is the only way to go. The application has to maintain four interrelated tables: transactions, sale increments, lots owned, and wash matches. Making it all work right is a complicated task, and it appears that even at some of the well-known brokerage firms the software isn’t always up to the task.