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The Final Word On The Tax 'Wash Sale' Rule

by: The Mad Hedge Fund Trader

Yes, it’s time for another boring tax story. And April 15 is still seven months off, so I can’t even use a tax-filing deadline as an excuse.

However, due to all the profitable trades the Mad Hedge Fund Trader Alert Service executed in September, I am getting a lot of questions about the dreaded “wash sale" Rule.

The wash what?

Yes, it's time for another boring tax story. And April 15 is still seven months off, so I can't even use a tax-filing deadline as an excuse.

However, due to the immense volume of profitable trades the Mad Hedge Fund Trader Alert Service executed in September, I am getting a lot of questions about the dreaded "wash sale" Rule.

The wash what?

The problem arises because the Internal Revenue Service believes that taxpayers are on a never-ending quest to avoid paying taxes. In that belief the despised government agency is largely right.

So what is the wash sale rule?

Let's say you purchase 100 shares of XYZ Corp. for $25 per share on February 10. Nine days later, on February 19, XYZ drops to $22 per share and you sell your 100 shares.

You now have a capital loss of $3 per share, or $300, which may be tax-deductible.

However, if on February 26, you then bought the same security for $22.50 per share, this would be considered a wash sale because you sold and repurchased shares of the same stock within only a few days.

Without the wash sale rule, the result would be that you could possibly have a tax deduction for your loss, but you would still own the shares, which is why it's called an "artificial" loss by the IRS, and therefore not deductible as a capital loss.

Don't try hiding your maneuvers by executing one leg of the trade in your personal account, and the second in your wife's account or your IRA. Both actions still trigger the wash sale rule.

The rule applies whether you are trading stocks, exchange traded funds, mutual funds, or options on any of the above. In fact, wash sales are quite likely if you have arranged for automatic reinvestment of your dividends back into your mutual funds.

The only requirement is that the two securities be substantially similar in nature, the precise definition of which the IRS has left intentionally and maddeningly vague.

The wash sale rule becomes an issue with the vertical bull call and bear put spreads the Mad Hedge Fund Trader has been recommending.

Usually, you are long one option and short another in the same company and both legs generate a profit on closing. No problem there. You just pay more in taxes and hope the government doesn't blow it on some useless program.

But during periods of extreme volatility, such as August and September 2015, it is possible to have a large gain on one leg, a substantial loss on the other, but to have a profit overall on the combined paired spread.

Enter the wash sale rule.

Since you had gains and losses in nearly identical securities within 30 days, the IRS will hit you with a short-term gain on the profit, but not let you deduct the loss. Yes, I know this sounds like a rip off, or a "heads I win, tails you lose" scam perpetrated by a devious IRS.

But it is not the end of the world. NO, I have not designed the most tax inefficient securities trading strategy imaginable. While you can't deduct the loss on the losing leg, you CAN use it to increase the cost basis on your winning leg, thus reducing your overall tax bill.

Also, the holding period of the wash sale securities is added to the holding period of the replacement securities.

Do this enough times, and you will eventually make it to the lower 20% tax rate for long-term capital gains. In this manner, the wash sale rule then becomes a convenient tax avoidance scheme, although it was certainly never intended as such.

So the losses ARE deductible at the end of the day. You just have to get your accountant to undergo some mental gymnastics and file the appropriate IRS Form 8949 to claim them indirectly. He'll charge you for the extra time. But at the end of the day, it is worth it.

As I am an "active trader" to say the least, in my case, these filings go on for dozens of pages. As a result, my annual tax return looks like the New York City telephone book. Actually, I'm told it's the same length as the corporate return filed by IBM (NYSE:IBM).

Now here are some warnings and provisos for the average taxpayer. If you use your friendly neighborhood tax preparer, one of the discount firms like H&R Block or Jackson Hewitt, or your fraternity brother from college using TurboTax to file your annual return, they may not know how to handle wash sales correctly.

You could well get stuck with the full loss because of their ignorance. So if you are an active trader yourself, or are dealing in large dollar amounts, I would recommend hiring an accountant who specializes in securities trading.

They will have all of the detailed knowledge readily at hand of the many obscure, arcane tax laws regarding securities trading, know of the recent relevant opinion letters issued by the IRS, and will be well aware of court cases regarding these issues.

Experts such as these can be found in abundance in New York and Chicago. They are easy to find on the Internet. Go to it.

Having spent 45 years dealing with tax matters, and devoting 10 years writing a weekly international tax column for the London Financial Times, I can tell you this is not a new problem.

Ignorance of tax problems outside of the plain vanilla questions is rife, even among accountants (yes, Sunday church deductions are tax deductible. Just make them by check so you leave an auditable paper trail).

There is no living person who knows what's in the entire 100,000 pages of the Internal Revenue Code, not even the IRS itself. That's a scary thought.

During the 1980s, the IRS sent an agent to England every year just to audit me because I was one of the ten highest earning Americans in the country.

For the last audit they sent a frumpy, bespectacled agent who had just spent a month auditing roustabouts on drilling platforms offshore from Louisiana, a notorious source of tax avoidance.

She didn't have a clue about how to interpret my multicurrency convertible home mortgage on my London mansion, so we spent the afternoon at the American embassy planning her European vacation to follow. I think I heard the CIA torturing someone in the next room.

Similarly, when I went into the oil and gas business in the 1990s, no California accountant could explain the tax benefits of that industry. I had to go to Houston to learn that, and what I discovered was a real eye opener. Why isn't everyone in the oil and gas business?

To learn about my last run in with the IRS, read "The Letter From the IRS You Should Dread."

For more background on the IRS, read "Happy Birthday IRS."

To get the official explanation of the wash sale rule in the IRS's own turgid, soporific bureaucratese, IRS Publication 550, see "Investment Income and Expenses (Including Capital Gains and Losses)."

Tax Forms

Watch Out for the "Wash Sale" Rule

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.