Understanding the Wash Sale Rule and Capital Loss Harvesting

Typical year-end tax planning involves the “harvesting” of tax losses.  The word “harvesting” means selling investments with unrealized losses in order to trigger tax deductions.  Taxpayers who allocate their investments across different asset classes will nearly always have some investments that lose money.  That is the nature of diversification.  Selling securities with losses will produce capital losses for income tax purposes.  These losses can offset capital gains and up to $3,000 of ordinary income.  Capital gain taxes can be surprisingly high given the layers of taxes imposed.  See the tax rates shown in the table below.

Prudent investors will want to repurchase securities to maintain their asset allocation percentages.  The “wash sale” rule is a tax rule that disallows the deduction of realized capital losses in certain circumstances.  The rule applies if the repurchased security is substantially identical to the security that was sold, and the repurchase occurs during the 61-day period starting 30 days before the date of sale and ending 30 days after the date of sale.  In other words, in order to deduct the capital loss, the government wants you out of the investment for at least 31 days before repurchasing the same security.  The date to be used is the “trade” date rather than the “settlement” date.  The loss disallowed under the wash sale rule is added to the cost of the replacement security.  So the loss isn’t permanently disallowed, it is just deferred until the replacement security is sold.

In order to trigger the tax loss but remain invested in the asset class, the replacement security needs to be a different security.  For example, you could purchase stock in another company in the same industry, or purchase a mutual fund from another fund family.

The wash sale rule also applies to related accounts and spouses.  The rule will apply if you use your IRA to purchase a substantially identical security to the one sold in your taxable account.  A husband cannot purchase the same security sold by a wife within the 61-day period and avoid the wash sale rule.

Capital Losses Can Save Taxes at These Rates	Top Federal Rate	Obamacare Rate	Itemized Deduct Phaseout	Utah Rate	Total  Tax Rate
Short-term capital gain	39.6%	3.8%	1.2%	5.0%	49.6%
Long-term capital gain	20.0%	3.8%	1.2%	5.0%	30.0%
Real estate recapture CG	25.0%	3.8%	1.2%	5.0%	35.0%
Collectibles capital gain	28.0%	3.8%	1.2%	5.0%	38.0%