For investors, a popular year-end tax planning strategy is to “harvest” investment losses. This strategy allows you to offset investment gains plus up to $3,000 in wages or other ordinary income ($1,500 if you use married filing separately status).

However, if you plan to repurchase the same, or a substantially identical, security after selling an investment at a loss, watch out for the “wash sale” rule. If you violate this rule, you’ll lose the ability to deduct your losses.

What’s loss harvesting?

Suppose you sold a few investments earlier this year and ended up with a net capital gain. If you own some investments that have declined in value, you might consider selling them at a loss to offset the gain and reduce your tax bill. This strategy is known as “harvesting” tax losses.

After harvesting a loss for tax purposes, you may want to repurchase the same investment. Perhaps you believe that the investment has great potential to rebound in the future. Or maybe it has sentimental value. That’s where the wash sale rule comes into play.

What’s the wash sale rule?

If you sell an investment to generate a tax loss and then quickly repurchase the same investment, the IRS views the tax loss as “manufactured.” The wash sale rule is designed to avoid this perceived abuse of the tax law by disallowing a loss if you buy a “substantially identical” security within 30 days before or after you sell a security at a loss.

For example, let’s say you purchase 100 shares of a stock for $100 per share. The stock’s value plummets to only $50 per share, so you sell it, generating a $5,000 capital loss. Three weeks later, the stock’s price declines even further to $40, and you purchase 100 shares for $4,000. The second purchase violates the wash sale rule, so you aren’t permitted to claim the $5,000 loss.

What happens to the disallowed loss?

When you sell an investment for less than you paid for it, you’ve experienced a real economic loss, so disallowing that loss for tax purposes may seem unfair. However, the wash sale rule doesn’t permanently deprive you of the ability to claim the loss. It merely defers it.

When a loss is disallowed under the rule, that loss is added to your tax basis in the replacement securities, reducing your taxable gain (or increasing your deductible loss) when you sell it.

How can you avoid the wash sale rule?

There are a few ways to avoid the consequences of the wash sale rule. The simplest is to wait at least 31 days before you buy the security again. However, keep in mind that there’s a risk that the price will have increased by then, erasing some or all of the tax benefits.

Another option is to “double up” on your investment — that is, buy the same number of shares of the identical investment and then wait at least 31 days before selling the original investment. If the price is still less than what you paid for the original investment, you can deduct the loss while keeping the investment in your portfolio. If the price goes up, you’ll enjoy additional gains.

Yet another option is to replace the original investment with one that’s similar but not identical (such as stock in a similar company in the same industry). One strategy that won’t work is to have a related party, such as your spouse or a corporation you control, buy the same security within 30 days before or after you sell it. The wash sale applies to such transactions as if you and your spouse (or your controlled corporation) are a single person.

Harvest with care

Harvesting investment losses can be a great way to lower your tax bill. If you take advantage of this strategy, pay close attention to your investments for the next 30 days to be sure you don’t run afoul of the wash sale rule. Contact your financial advisor for more details.

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