Tax-loss selling is an investment strategy that can help an investor reduce their taxable income for a given tax year. Tax-loss selling involves selling a security that has experienced a capital loss in order to report it as a capital loss when filing yearly income taxes, and thus lower or eliminate any capital gain that may be realized by other investments.

In order to successfully realize the loss for tax purposes, you have to take the step of liquidating the position during the tax year. Any unrealized loss on an investment cannot be deducted from your income taxes.

Sometimes an investor will decide to replace that security with a similar security, allowing them to maintain a consistent, optimal asset allocation and achieve their desired returns. If you take this approach, it is important to be mindful that you do not accidentally trigger a wash sale in your investment account.

What Is a Wash Sale?

A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days of the sale (either before or after), you purchase the same—or a “substantially identical”—investment. The wash-sale rule is a regulation established by the Internal Revenue Service (IRS) in order to prevent taxpayers from being able to claim artificial losses in order to maximize their tax benefits.

When a wash sale occurs in a non-qualified account, the transaction is flagged and the loss is added to the cost basis of the new, “substantially identical” investment you purchased. If you continue to trade the same investment, the loss gets carried forward with each transaction until the position has been fully liquidated for more than 30 days.

The same rules apply if the spouse of the individual that sells the security, or a company controlled by that individual, purchases the same or substantially equivalent securities within the 30-day timeframe.

In addition, your holding period for the new stock or securities (for designating whether or not the investment will represent a short- or long-term capital gain) includes the holding period of the stock or securities that were previously sold.

Investments Subject to Wash Sale Rules

The wash-sale rule applies to stocks or securities in non-qualified brokerage accounts and individual retirement accounts (IRAs). The sale of options at a loss and the reacquisition of identical options within a 30-day timeframe would also violate the wash-sale rule.

The IRS provides guidelines about what is considered a “substantially identical” investment and thus may trigger a wash-sale violation, in IRS Publication 550, entitled “Investment Income and Expenses (Including Capital Gains and Losses). A substantially identical investment can include both new and old securities issued by a corporation that has undergone reorganization, or convertible securities and common stock of the same company.

When an investor holds several different investment accounts, wash-sale rules apply to the investor, rather than to a specific account. The IRS requires that brokers track and report any sales of the same CUSIP number in the same non-qualified account. However, investors are responsible for tracking and reporting any sales that occur in all other accounts that they control, including any accounts belonging to their spouse.

Offset Capital Gains Through Tax-Loss Selling

While some investors turn their attention to tax-loss selling towards the end of the calendar year, it is possible to use this strategy throughout the year to capture tax losses through rebalancing or replacing positions in your portfolio. Capital losses are used first to offset other taxable capital gains. After this, up to $3,000 per year can be used to offset other taxable income for an individual filer or married couple filing jointly (up to $1,500 for married filing individually).

For example, if an investor realizes $5,500 in long-term losses during the year, at the time that they file their income taxes, they can use $2,000 of those losses to offset the taxes on other capital gains and $3,000 to offset the taxes on their ordinary income. If this investor’s long-term capital gains tax rate is 20% (based on their income) and their effective federal income tax rate is 25%, using this strategy the $5,500 loss can be reduced by $1,150.

Depending on the state they live in, the investor may also be eligible for a reduction in their state taxes. The remaining $500 in capital losses can be carried forward to future tax years. Unfortunately, losses cannot be transferred at death.

Strategies for Avoiding Wash Sales

There are strategies for avoiding wash sales while still taking advantage of taxable gains and losses. If you own an individual stock that experienced a loss, you can avoid a wash sale by making an additional purchase of the stock and then waiting 31 days to sell those shares that have a loss. A potential drawback of this strategy is that it can increase your market exposure to a given sector and could potentially increase your risk.

In this same situation, an investor may decide to liquidate the holding, recognize the loss, and then immediately buy a similar investment that will also satisfy their investment goals or portfolio allocation. For example, an investor may decide to sell their stock of The Coca-Cola Company (KO) and then immediately purchase a similar investment of PepsiCo, Inc. (PEP).

Similarly, an investor may decide to sell their shares of the Vanguard 500 Index Fund (VFIAX) and replace them by purchasing shares of the Vanguard Total Stock Market ETF (VTI).  

Correction: January 20, 2022. The offset amount for individual taxpayers was incorrectly specified in a previous version of this article.