This article will be limited to discussion of stocks only, but be forewarned that wash sale and constructive sale rules can also apply to options trading. Discussion of options will be deferred to Parts V and VI, to be available soon.
Wash Sale Rules
The wash sale rule seems to me an anachronism in these times of in-and-out trading, but it is an anachronism that when followed properly generates a lot of tax revenue, so it is a safe bet that it is not going away. And now, with the new reporting rules, it will probably be followed properly much more frequently than before. It applies to investors, and also traders who have not made a MTM election.
It can come as a shock to the unaware speculator to learn that significant losses are disallowed, at least for the immediate tax year, because of the wash sale rule, and that the tax bill to be paid is much higher than what was expected. The essence of the wash sale rule is that a holder of a loss position cannot take the loss for purposes of offsetting other gains or reducing tax owed, if the position is reacquired within 30 days of the sale, presumably with an expectation that the position will recover, and that the loss was temporary. It applies as well if the replacement shares were acquired before the wash sale, if the new shares were acquired less than 30 days prior to the sale. I suppose that the rule was instituted because clever stock operators sold out their losers at year-end and reported the losses, even as they more or less concurrently reestablished the sold positions. The IRS considers that a loss sustained in this fashion is not a real loss, since the position was reinstated. The wash sale rules have been instituted to reflect and impose the IRS view. While it applies to various situations, it is most easily explained by considering a long stock position. The rule states simply that if you sell a stock at a loss but then reacquire the position during the wash sale period, the loss is disallowed. The wash sale period is the 61 day period beginning 30 days before the stock sale and ending 30 days after the sale. Days in this case refers to calendar days. Gains are not affected by the rule -- they are still reported in all cases. Sales within 30 days of purchase which result in a loss are likewise not affected, as long as no additional shares are acquired during the 61 day wash sale period. That is, if shortly after purchase you determine it was a mistake, you can sell all or part of your position and claim the loss, as long as no additional stock is acquired during the wash sale period. Acquiring a replacement position triggers the rule even if the position is acquired in a different account, even an IRA. While I will defer bringing options into the discussion at this point, but be aware that entering an option position which effectively reestablishes a sold position, with the subject stock as the underlying, can also in certain cases trigger the wash sale rule.
The disallowed loss is not necessarily foregone permanently. In the case of a stock sale and repurchase, for example, the disallowed loss is added to the basis of the stock repurchased, thus reducing a future gain or increasing a future loss, when the replacement shares are sold. If the position reacquired is later sold and the subsequent aggregated result is still a loss, it can then be claimed as a capital loss if the investor can refrain from buying the position back yet again during the wash sale period of the last sale. Also, the holding period of the replacement shares is considered to be the time these shares were held plus the holding period of the shares for which the loss was disallowed. But note that the time from the original wash sale to when the stock was repurchased, if there was a gap, does not count when computing the replacement position holding period. Also, note that if the wash sale is invoked because the reacquisition occurred in a retirement account, there is no recovery of the disallowed loss.
If a trader is day trading or swing trading a stock, gains are reported, but losses are disallowed by the wash sale rule. But, any disallowed loss is added to the basis of the buy which triggered the wash sale. If more gains than losses occur, the losses will eventually be used up by reducing gains. If after a long string of trades, the cumulative result at the end is still a loss, the trader can then cease trading the stock for over 30 days, and the loss can be claimed on the last trade. This requires very careful record keeping, which can be an even bigger nightmare if unequal quantities are purchased, but it is possible to track it through and report it properly if the rules are understood.
Wash sale rules can apply to short sales. Consider the most straightforward cases, with no long stock positions or option positions. If the short sale is closed at a loss, but then the same stock is sold short again within 30 days of closing the original short position, the loss is disallowed, per the wash sale rule. The disallowed loss is factored into the gain-loss determination when the second short position is closed, and thus can be eventually used.
A loss on a short sale is also disallowed if the stock is repurchased within 30 days of closing the short position.
Short Sales - Basics
Short sales with no pre-existing long stock position in the same security held concurrently, no long stock position in the same security acquired while a short position is on and then held concurrently, and no related option positions held, are fairly straight-forward. If the short position appreciates and is covered at a gain, the result is a short-term capital gain. The holding period is based upon how long the shares used to cover the short were held, which is one day in the case where the short is closed by purchasing new shares, which are then delivered to cover the short. Similarly, if the short position resulted in a loss, the result is a short-term capital loss. The gain or loss is reported on Form 8949 in the year that the short position was covered. For a loss, this assumes the wash sale rule is not applicable, as described above.
Short Sale Rules per TraderStatus.com states that for short sales resulting in a loss, the settlement date of the closing purchase is the date to use for tax reporting of when the position was closed. For short sales resulting in a gain, the trade date of the closing purchase is the date to use. I had thought that the trade date was the date to use in all cases. A link to this resource is provided under Resources, below. The only reference to this point that I have found in IRS literature was in Publication 550, which states that if the trade date for a short position covering purchase occurred on the last day of a year, and thus the shares will not actually be delivered until the next year, the short sale is still reported in the year of the short covering purchase trade date.
Short Sales and Constructive Sale Rules
When short positions and long stock positions in the same security are held concurrently, for at least part of the time that a short position is open, things can get much more complicated in a hurry, due to IRS rules on constructive sale of an appreciated financial position. As used here, a "sale" is a closing of the appreciated position, and in the case of an appreciated short position, purchasing the stock while retaining the short position would trigger the constructive sale rule. The essence of the rule is that the IRS considers a position to have been closed if it has appreciated and an offsetting position is acquired, even when the offsetting transaction is not used to close the appreciated position, and the investor has both positions on going forward. The investor must report the transaction accordingly, and make necessary adjustments to the positions retained going forward, to reflect the constructive sale. While it may not seem logical to be long and short a stock at the same time, and in fact may not be possible within a single account with some firms, it certainly can occur if a trader has multiple accounts. One popular strategy involving concurrent long and short positions was known as "going short against the box". It was commonly used before the constructive sale rules effectively eliminated the practice in 1997.
It is beyond the scope of this article and this author to lay out all possible scenarios and confidently state how they should be handled. The best that I can do is to define all possible scenarios and provide my best guess, confidently or not, as to how they should be handled, based on the resources I am relying upon, and some assumptions. The results are presented in several tables provided below. The first set of tables covers various scenarios whereby a long stock position is held prior to a short sale, then a short sale is executed, and both the long and short positions are retained for a time going forward. The second set of tables covers various scenarios whereby the short sale occurs first, then stock is purchased, and again both the long and short positions are retained for a time going forward. Even if I have gotten it wrong in a case or two, as far as defining how to handle a situation, I believe there is value in laying out all the combinations for consideration, to alert readers to these possible complexities. Just keep in mind that this section only refers to concurrent long and short stock positions in the same security, and the entire mess can be avoided easily enough by avoiding these situations. Knowledgeable tax assistance for complex trading strategies is hard to find, and expensive when found. The best advice I can offer for less sophisticated investors is probably to avoid transactions which introduce these complexities in the first place.
First Set of Tables - Long Position Acquired Prior to Short Sale
Long Position Was Long-Term at Point of Short Sale
Long Position Was Short-Term at Point of Short Sale
Reference Notes for Preceding Two Tables - Long Position Existed Prior to Short Sale Initiated
Note1 - This is the infamous "short against the box" situation, a common strategy followed before the Constructive Sale (CS) rules were instituted. If the long stock had appreciated, the IRS considers that the short sale in this case represents a constructive sale of an appreciated financial position, and must be reported as if the stock had been sold at the point when the short position was initiated.
Note2 - The CS treatment can be avoided if the short position which caused it is covered at any time within 30 days after the end of the year in which the short sale was entered, as long as two other conditions are met - the long stock position must be held for at least 60 days after the short was covered, and no offsetting positions can be entered during the 60 days that reduce the risk of the long position.
Note3 - The CS rule treats the long stock position as if it had been sold and then immediately repurchased at the point of the short sale. The holding period of the long position starts over, and the cost basis is the Fair Market Value (FMV) at the point of the short sale, presumably the short sale price.
Note4 - The IRS rules state that if a long stock position is held LT at the time a short sale is entered, and the short sale is later closed at a loss, the loss must be reported as a long-term loss (which is less favorable for the taxpayer than a short-term loss).
Second Set of Tables - Long Position Acquired After Short Sale
Short Position Had Appreciated When Long Stock Position Initiated
Short Position Had Not Appreciated When Long Stock Position Initiated
Reference Notes for the Two Preceding Tables - Long Stock Position Acquired After Short Position Initiated
Note1 - Similar to the case when an appreciated long stock position exists when a short sale occurs, if an appreciated short position exists and stock is purchased, the IRS considers that the Constructive Sale (CS) rule applies, and if no action is taken to avoid it, the stock purchase is considered to have closed the short position at a gain, to be reported accordingly.
Note2 - I am assuming treatment by the IRS of the CS situation regarding an appreciated short position and a long stock purchase parallels the treatment of an appreciated long position when a short sale occurs. Assuming this, then the CS can be avoided if the long stock position is sold at any time within 30 days after the end of the year in which the stock was purchased, as long as two other conditions are met - the short position must be held for at least 60 days after the stock was sold, and no offsetting positions can be entered during the 60 days that reduce the risk of the short position. I have not located any resources that confirm this assumption. I am assuming reciprocity applies.
Resources and Disclaimer
All of the preceding is based on my review of the following resources:
J.K. Lasser's Your Income Tax for 2013, available from bookstores everywhere.
Taxes and Investing Brochure from the Options Clearing Corporation (OIC), available online as a PDF file here.
Short Sale Rules per TraderStatus.com, a link to which is provided here.
Constructive Sale Rules articles by Roy Lewis, available here from Fool.com. This is the first of a four-part series on the topic. Links to the companion articles are provided in each of the articles in the series.
IRS Blows Up Short-Against-The-Box article by John Thackray.
Various IRS Publication, particularly the 1040 Instruction booklet, with instructions included for schedule A, B, C, D, and E, and Publication 550, Investment Income and Expenses. A link to the IRS website is provided here.
While I have made a good faith effort to understand and present the topics discussed in this article, relying upon the resources cited, I want to reiterate that I am not a financial professional, nor am I certified in any way as a financial advisor or tax expert. I am an independent, individual investor, focusing on dividend-paying stocks exclusively. I am always seeking to become more knowledgeable on investments and related topics, and on sharing what I have learned with other investors in similar circumstances. Also, I want to reiterate a caution mentioned in the first paragraph of Part I and in the Disclaimer section of all succeeding articles, which is that the points I am bringing out are limited to commonly occurring situations that investors in publicly traded stocks and options experience, with positions held "in street name" in brokerage accounts. Readers need to realize that the information as presented is not all-inclusive, and that there are many exception conditions and special cases that are not discussed. In the case of concurrent long and short positions and constructive sale rules, I will again express my reservations regarding what I have assembled and provided in the tables, which has required me to make some assumptions for some of the cases. I still believe there is value in what I have presented, in that readers can at least become aware of these issues and the tax complications that can result.
Investors are advised to seek professional tax advice and assistance in handling their own tax situation. However, becoming a knowledgeable and conversant client on tax issues affecting investors will save time and money, and will improve the likelihood of correct tax filings.
The final two topics in this series are devoted to options and taxes. Beginning in 2013, brokerages will be required to report cost-basis and holding periods for options positions, which will be reconciled on Form 8949, similar to how stock trades have been handled since 2011. While options are currently reportable, brokerages do not currently provide the IRS with details on options trades. Trading options can introduce numerous complications into an investor's tax situation. Awareness of these "land mines" is essential if an investor is to avoid unexpected tax consequences of certain actions. Coming up next is Part V - Options, the first of two articles devoted to options and taxes.