This tax season — the one that just ended for those lucky enough to have filed on time, and the one still painfully dragging on for those who filed for an extension — is the first for which brokers are required to report cost basis, in addition to gross proceeds, on Form 1099-B. An important part of the requirement is that brokers must apply the wash sale rule, which prevents you from claiming a loss on a sale of shares if you buy identical shares within 30 days before or after. Anyone who does a lot of buying and selling might wonder whether the broker applied this rule correctly. You may be surprised to learn that there’s no way to be sure. The wash sale rule is a lot more complicated than it appears, and there are unanswered questions about some aspects of its workings.
One issue has to do with the way we adjust the holding period when the wash sale rule applies. The law says the holding period of the replacement shares has to be adjusted to include the time you held the shares that were sold at a loss. There are at least three reasonable ways to interpret this rule: (1) count the number of days you held the shares sold at a loss and add that to the number of days you’ve held the replacement shares, (2) same as the first one, but without double-counting days if there is an overlap in ownership, which occurs when the replacement shares are bought in advance, before shares are sold at a loss, and (3) treat the replacement shares as if they were acquired on the date you acquired the shares that were sold at a loss. The interpretation of this rule can determine whether you have a long-term holding period when you sell the replacement shares. Equally important, it can determine the order of disposition when you make subsequent sales, if you’re selling according to the first-in, first-out method, or FIFO.
Amazingly, although the wash sale rule has been in place for many decades, the IRS has never provided authoritative guidance on which interpretation we should use. The second one is probably the closest match for the language in the law, but I’m not aware of anyone actually using it. The third one makes the most sense from a policy perspective, and was reflected in IRS Publication 550 for a number of years. A few years ago, however, someone at the IRS, mistakenly in my view, decided to remove that language from the publication. This change has led many tax experts to recommend choice (1) above, even though it produces strange results — you can be treated as having a holding period that began earlier than the date you opened your account and began trading, for example. In any event, IRS publications don’t qualify as authoritative guidance, so we’re forced to make our own interpretation and hope it’s considered the correct one.
A much trickier area involves the replacement shares concept. A simple example is where you buy 200 shares in a single transaction and, less than 30 days later, sell 100 of them at a loss. You’ve met the conditions for the wash sale rule to apply because at the time of the sale you hold identical shares that were purchased less than 30 days before the sale. It doesn’t make sense to apply the wash sale rule here, though, because it’s clear that the remaining shares weren’t purchased to replace the ones you sold. The IRS issued a ruling many years ago saying the wash sale rule won’t apply merely because you continue to hold shares purchased in the same lot as the one from which you sold shares at a loss.
Consider this scenario, however. Six months ago you bought 100 shares of stock, and they’ve declined in value. You’d like to continue holding them but you’d also like to claim the loss on your tax return. Instead of simply selling the shares and buying them back, which would trigger the wash sale rule, you buy 200 shares and sell the original 100 shares. This triggers a wash sale and leaves you with 200 shares that were all purchased in a single lot. The shares don’t all have the same tax characteristics, however. Because 100 of them were replacement shares for the 100 original shares that were sold at a loss, we had to adjust their basis and holding period. What happens if you now sell those 100 replacement shares?
Because of the basis adjustment from the earlier wash sale, you would have a loss on this sale — essentially the same loss you had when selling the original shares. It might seem that the wash sale rule should apply because you still own 100 shares you bought less than 30 days earlier. However, the shares you’re now selling (the 100 replacement shares) and the shares you still own after this sale were all purchased as part of a single lot of 200 shares. If you can rely on the IRS ruling mentioned earlier, the wash sale rule won’t apply. Yet it’s clear that the wash sale rule should apply, because all you’ve really done is buy 200 shares and sell 200 shares, ending up with 100 shares, which is where you started. If the IRS ruling applies to this situation, taxpayers have an easy way to avoid the wash sale rule.
When the Treasury was developing the cost basis reporting rules I submitted comments explaining the need for guidance in this area. Others commentators said brokers shouldn’t have to apply the wash sale rule at all. The Treasury rejected both suggestions, and the result is that brokers are required to apply these rules, and are potentially subject to penalties for failing to apply them correctly, even though we haven’t been told what is the correct way to apply them. In consulting with software developers I’ve had to tell them there are no clear answers to these questions and that we have to select a workable and defensible interpretation. Because of these ambiguities, investors have no way to be certain the tax reports they receive from brokers are correct, even if the broker has implemented the rules as thoughtfully and accurately as possible.