How the wash sale rule applies to stock traders.
Most investors run into the wash sale rule only occasionally. If you’re an active trader, you’re likely to have a large number of wash sales each year.
Discussion of many tax rules for traders appears in our online Tax Guide for Traders, and a more detailed discussion appears in our book, Capital Gains, Minimal Taxes.
Generally, the wash sale rule applies to traders the same way it applies to investors. The difference is that traders have a much harder time keeping records relating to wash sales because they engage in so many transactions.
There is a way for traders to escape the wash sale rule altogether. If you qualify as a trader, you can elect to adopt a system of accounting called “mark-to-market” accounting. This election has other significant consequences besides eliminating the wash sale rule, and may not be the best choice in all cases.
Before we get too far into this topic, we need to be clear on what a trader is. This term has special meaning in the tax law. You may be a trader in the usual sense of that word without being a trader for tax purposes.
Generally you’re a trader if two things are true. First, your trading strategy is designed to profit from short-term swings in prices rather than from long-term appreciation. If you pick up any interest or dividend income, that’s purely incidental, not part of your main strategy. Second, you do enough trading on a regular basis over a period of time so that it’s fair to say you’re carrying on a business, as opposed to merely trading in your spare time. If you’re uncertain whether you’re a trader for tax purposes, visit our Tax Guide for Traders.
The General Rule
There’s confusion, even among some tax professionals, as to whether the wash sale rule applies to traders. There are even some professional publications that aren’t completely clear on this point, although the law is entirely clear. At one time, corporations that carried on a trading business were subject to the wash sale rule, but individual traders were not. Congress decided it wasn’t appropriate to make this distinction, so the law was changed. Under current law, both individual traders and corporate traders are subject to the wash sale rule.
The Treasury has never gotten around to changing the regulations on this point, so the regulations still say the wash sale rule doesn’t apply to individual traders. But you’re not allowed to rely on a regulation that was issued before Congress changed the law. The Internal Revenue Code is clear on this point, and the relevant committee report specifically mentions the intention for the wash sale rule to apply to individual traders. You may not like it, but it’s the law: the wash sale rule applies to traders.
Clearing the Tax Effects for a Year
If you make hundreds or thousands of trades each year, the record keeping required for compliance with the wash sale rule can become extremely difficult. You may get to the end of the year not knowing whether you have disallowed losses or, if so, the magnitude of the disallowed loss. If you have a sizeable disallowed loss, you can end up paying tax on an amount that exceeds your economic income for that year. There’s a way to eliminate that possibility: take a winter vacation from trading. Or at least from trading the stocks you trade during most of the year.
When you make a wash sale, the disallowed loss gets added to the basis of the replacement stock. If you sell the replacement stock within the same year — and wait at least 31 days before buying that stock again — you wipe the slate clean. You can report all your gains and losses as if the wash sale rule didn’t apply, because the only effect of the rule in this case is to move your loss from one transaction to another within the same year.
Example: During most of the year you actively trade XYZ. On December 15 you sell all your positions in XYZ and don’t buy any more of this stock until January 15 (31 days later). Meanwhile you enjoy the holidays, and if you get the itch to trade, you dabble in ABC.
Of course you could run into the wash sale rule in your ABC trading, but this arrangement clears away the tax effect of any wash sales you have in XYZ.
There are a few technicalities to note. First, if you owned XYZ before the start of the year, the wash sale rule could cause some losses that appear to be short-term losses to transform into long-term losses. This method of clearing your wash sales is 100% clean only if you were out of XYZ at both the beginning and the end of the year.
Second, it isn’t enough to simply stop trading XYZ for 31 days. You have to be out of XYZ for 31 days. If you stop trading while holding a position in this stock, there’s no way to tell whether you’ll be affected by the wash sale rule without doing an analysis of all your trades for the year.
And third, there’s at least one situation where it makes a difference how much income or loss you had in a particular part of a year. If you fall short on your estimated tax payments, you can reduce or eliminate the penalty by showing that most of your income came later in the year. In theory, if you use this approach to handling your estimated taxes, the IRS could say you had more income earlier in the year (and less income later in the year) because of the wash sale rule. Frankly, I don’t think anyone other than me would think of the wash sale rule in this context, but since I thought of it I might as well mention it.
Although this “winter vacation” idea can clear out the tax consequences of wash sales, it doesn’t relieve you of the obligation to report all trades on Schedule D, reporting any wash sales appropriately. If you have a large enough volume of trades, the only realistic way to handle the problem is with software specially designed for this purpose.
The Mark-to-Market Election
Full details on the mark-to-market election are beyond our scope at this point, but it’s worth pointing out that a trader who makes this election isn’t subject to the wash sale rule. There are some other important things you should know if you’re thinking of making this election.
- If you make this election, all your trading gains and losses will be treated as ordinary income, not capital gain.
- If you make this election, any stock or other trading asset you hold at the end of the year is “marked to market.” This means you report gain or loss as if you sold it at the close of business on the last trading day of the year for its fair market value.
- Once you make this election you’re stuck with it. You can revoke it only with the consent of the IRS.
It’s easy to see why the wash sale rule doesn’t apply if you make this election. All your gains and losses are reported at the end of the year, whether you sell the stocks or not. There’s no point in worrying about whether someone sold the stock and bought it back.