Losing money on an investment is bound to shock you up, but capital losses can be helpful when paying taxes because you can deduct such losses from your capital gains.
However, if you don’t tread carefully, you can end up decimating the benefits of a capital loss.
If you violate the “wash sale rule,” you delay your opportunity to knock off your capital losses, and you might lose out on the deduction permanently.
Mitigating Your Taxes Through The Wash Sale Rule
Tax-loss selling is an investment strategy to help an investor take-the-edge-off of their taxable income for a specified tax year.
Tax-loss selling deals with selling a security that has witnessed a capital loss to report it as a loss while filing yearly income taxes, and hence lowering any capital gain to be realized by different investments.
To successfully realize loss while filing taxes, you need to liquidate the position during the tax year. An unrealized loss on an investment is not liable to be deducted from your income taxes.
Nowadays, investors choose to replace that security with substantially-similar security, enabling them to maintain a consistent, ideal asset allocation and attain their desired returns.
This approach can help you save taxes; however, you must remember not to trigger a wash sale in your investment account.
When the wash sale rule is triggered, the net amount of the investor’s loss is summed to the cost basis of the purchased replacement investment.
This situation adjourns the loss until a future date when the replacement investment is finally sold off.
Investors must always avoid violating the wash sale rule by investing in substantially identical security in an IRA.
This kind of transaction could result in the permanent disallowance of the capital loss, and not simply transferring the tax benefit to a later date.
Avoiding Wash Sales And Still Saving Taxable Losses
You must try to avoid the wash sale rule by selling a security at a loss and invest in something with similar exposure.
There are certain strategies to avoid wash sales while still seeking advantage of taxable gains and losses.
If you own a specific stock that experienced a loss, you can steer clear of a wash sale by making an additional investment of the stock and then waiting it out for 31 days to sell shares that are at a loss.
However, it can escalate your market exposure to a particular sector and even potentially increase your risk.
In a similar situation, an investor might want to liquidate the holding, acknowledge the loss, and immediately purchase a similar investment to satisfy their investment goals or portfolio allocation.
Let’s consider this instance, where an investor sells their stock of The Coca-Cola Company (KO) and then immediately buys a similar investment of PepsiCo, Inc. (PEP).
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1. Tax Loss Harvesting
In tax-loss harvesting, you sell your stocks/fund units at a loss to gain a reduction of tax liability on your capital gains made by selling profitable stocks.
Tax Loss Harvesting can be really helpful in saving taxes. Once the losses are sold, you need to wait for 30 days prior to investing in a similar stock. This practice is performed to avoid wash sales.
Taxpayers mitigate their capital gains to reduce their overall taxes. After selling their stocks at a loss, investors tend to buy the same or substantially-similar stocks to account for the incurred loss.
To harvest a tax loss successfully, you are required to monitor your asset allocations, and make sure that the replacement assets bought aren’t substantially identical.
This kind of strategy is extremely effective to avoid wash sales and reduce your taxes liable on other capital gains.
2. Trading Via Taxable as-well-as IRA Accounts
You can avoid a wash sale loss by exploiting the idea of trading using both taxable and IRA accounts.
If a stock is sold-off in a taxable account and later a substantially identical stock is bought within 30 days within an IRA account, Wash Sale loss can be completely avoided.
Brokers don’t evaluate WS losses in more than one account; hence no report on the wash sale is generated. If you trade in an IRA alone, then wash sales can be avoided.
Wash sales are reviewed carefully by the IRS; hence it is best to avoid it by waiting out the 61 days and invest in substantially-similar stocks if you want to after this period.
3. Added Investments
If you own a stock with a loss and desire to sell it but also don’t want to be out of the market wholly, consider investing in another additional stock and wait for 31 days to sell the stocks that bear a loss.
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4. Entity Account Trading
Executing trades in an entity account to steer clear of wash sale losses is also a great idea.
This is substantial because the company’s account is considered as being separate from the individual or IRA accounts. This practice is done to completely avoid wash sales.
5. Partial Regain of Sold Stocks
Traders employ the strategy of implementing partial deductions to save taxes.
This enables you to have some portion of your investment by selling-off a greater number of stocks than what is purchased later within the 61 days around the transaction.
The remnant loss incurred doesn’t vanish but is deferred, only to be dealt with later.
The wash-sale rule is the way of IRS to limit stock sales that are fueled primarily due to tax reasons. Some investors might not appreciate it, while others regard it as being valuable and yielding.
Investors tend to avoid it to mitigate taxes or extrapolate some ways to work around a wash sale. It’s advisable to maintain a clean portfolio.
It might be tough trying to avoid triggering a wash sale and might not always be your best bet.
Understanding the trade-offs can help you attain your goals efficiently, whether they implement strategies to avoid wash sales or accept them or rather devise ways to work around a wash sale.