Last Updated on September 27, 2023 by BFSLTeam BFSLTeam
The act of buying and selling securities in the stock market has several tax implications that you need to know about. As an investor, being aware of the various ramifications is crucial to ensure you don’t get into any trouble with the law. One of the many tax implications that you need to be aware of when trading or investing in the U.S. stock market is the wash sale rule. If you’re not careful, you can end up inadvertently triggering this rule, upending your carefully crafted trading plan. Want to know more about the wash sale rule and how it can affect your trading and investment decisions and strategies? Continue reading to find out.
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What is the Wash Sale Rule?
The Internal Revenue Service (IRS), which is the U.S. equivalent of the Indian Income Tax Department, enacted the wash sale rule in 1921. According to this rule, the losses arising from a wash sale cannot be used to offset the profits you earn from trading or investment to reduce your tax liability.
A wash sale is when you sell a security at a loss and then buy the same or a very similar security (futures and options contracts of the said security) 30 days before and after the loss-making trade including the day of the sale transaction. The IRS also classifies a loss-making sale made by your spouse or a company controlled by you during the 61-day waiting period as a wash sale.
Some investors use temporary dips in asset prices to sell their loss-making positions, thereby inducing artificial losses. Once the loss is realised, these investors quickly purchase the asset once again at this new low point. The induced losses are then used to reduce their tax liability by setting them off with the profits they make from other trades.
The primary objective of enacting the wash sale rule is to prevent investors from booking a loss to reduce their tax liability while continuing to hold a similar position in a security.
Wash Sale: An Example
Now that you’ve seen what the wash sale rule is, let’s take a look at a couple of hypothetical examples to better understand the concept.
Example 1
Let’s say that you’ve purchased 100 shares of a company XYZ Inc. at $100 per share. The total value of the trade is $10,000 (100 shares x $100 per share). Now a few days later, the company’s share price drops to $80 per share. Instead of holding onto your position, you square it off and book a loss of $2,000 (100 shares x $20 per share) intending to use the loss to offset the profits you earned in a previous trade.
However, three days later you purchase 100 shares of the same company XYZ Inc. which is now trading at $70 per share since you feel that the share price is now very attractive and is likely to rise in the future.
According to the wash sale rule by the IRS, the loss-making trade is considered to be a wash sale. This effectively means that you cannot use the loss of $2,000 to reduce your tax liability.
That said, if you purchase 100 shares of XYZ Inc. once again after 31 days from the initial loss-making trade, you will not invoke the wash sale rule. This will allow you to claim the loss of $2,000 as a deduction from the profits earned during a previous trade.
Example 2
Now, assume that you purchase 100 shares of ABC Inc. at $1,000 per share. However, a few days later, the share price drops to $800 per share. You decide to make use of this temporary dip by buying 100 more shares at $800 per share.
However, along with this new trade, you also sell the first lot of 100 shares of ABC Inc. at a loss of $200 per share. Since you’ve purchased the same security 30 days before the initiation of the loss-making trade, you end up invoking the wash sale rule by the IRS. This effectively means that you would be unable to reduce your tax liability by deducting the loss from the sale of 100 shares of ABC Limited from your other trading profits.
The best way to avoid intentionally or unintentionally triggering a wash sale is to wait for 31 days (including the day of the loss-making transaction) to expire before purchasing the same asset once again.
Does the Wash Sale Rule or its Equivalent Exist in India?
The wash sale rule is a tax concept enacted by the Internal Revenue Service (IRS), the primary tax authority of the United States of America. This means that this rule is very unique to the U.S. stock market.
As far as the Indian stock market is concerned, the concept of wash sale doesn’t exist. This effectively means that you can freely deduct losses from any trades from your profits to reduce tax liability even if you purchase the same or a similar asset immediately afterwards.
In fact, many traders and investors in India actively use several tax loss harvesting strategies to reduce their liability without worrying about their losses being disallowed due to the contravention of the wash sale or other equivalent rules.
So the next time you find yourself with a loss-making position when trading or investing in the Indian stock market, feel free to square it off and realise the loss. If you still find the stock attractive even after it has lost its value, you may consider entering into a new long position.
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Conclusion
The primary objective behind the Internal Revenue Service (IRS) enacting the wash sale rule in the U.S. is to prevent traders and investors from using the various tax provisions to lower their liability. Therefore, if you’re someone who actively trades or invests in the U.S. stock market, you need to keep this particular rule in mind before squaring off your loss-making positions.
However, if you do end up squaring off a loss-making position, remember to not enter into the same or a similar position once again before the expiry of 31 days from the date of square-off. This will enable you to claim the loss you suffered due to the square-off from the profits you made through trading and investment.
On the other hand, if you’re not interested in deducting the loss from your profits, you can disregard the wash sale rule entirely and continue to buy and sell your preferred securities normally.
