A wash sale is what happens when an investor sells a security at a loss and buys a similar or identical security either 30 days before or 30 days after the sale. Normally, the investor would be able to claim the loss as a tax deduction. However, this is not allowed with a wash sale. That said, there are ways the investor may be able to turn the situation to his or her advantage, provided he or she follows the proper tax laws.

Understanding Gains and Losses

When an investor earns profit by selling a security, the profit is taxed as a capital gain. The investor can offset this tax if he or she sold any other security at a loss. Whatever the investor lost gets subtracted from whatever the investor gains. If the two numbers are equal, the investor does not have to pay any capital gains tax at all. If the value of losses exceeds the value of gains, he or she can claim the difference as a tax deduction.

If the investor owns a security that lost value, he or she may be inclined to sell it at a loss to claim the tax deduction. However, the investor may be hesitant to do that if he or she feels that the security's value may bounce back in the future. The wash sale allows the investor to have the proverbial cake and eat it too. The investor sells the security at a loss and then buys a similar or identical security. If the market improves, the investor would still be able to earn profits.

Understanding Wash Sales

The investor would not be able to claim the loss as a tax credit if he or she bought the replacement security either no more than 30 days before the sale or no more than 30 days after the sale. This is known as the wash sale. The time is counted based on the calender days rather than trading days. Furthermore, the rule applies even if the investor did not actually acquire the replacement security within the 60-day limit. Merely entering into a legal contract to buy a security is enough.

Basic Adjustment

As mentioned above, investors cannot claim the losses within the 60-day window. However, the basic adjustment allows investors to apply that loss towards the price of the replacement security. In other words, for tax purposes, the security is worth the purchase price plus the value of the loss. Once the investor decides to sell the security, the gains and losses are calculated accordingly. This is something of a double-edged sword. While, ideally, it would reduce the gain and increase the loss, it will do the opposite if the market is not doing well. This is why investors should remember how much they lost when they sold the original security and make their decisions accordingly.

Holding Period

Holding period is the time between the day the investor bought a security and the day he or she sold it. In the wash sale, the holding period for the original security is automatically added to the holding period of the replacement security. It also means that any losses are treated as long-term losses rather than short-term losses. While this will reduce the tax on above-mentioned capital gains, it will also reduce the tax deduction on the losses.

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