The Wash Sale Rule Explained: IRC Section 1091 for CPA Candidates

The Wash Sale Rule Under IRC Section 1091

The wash sale rule prevents taxpayers from claiming a tax loss on the sale of a security if they purchase a substantially identical security within a 61-day window surrounding the sale. This window extends from 30 days before the sale through 30 days after the sale. The purpose of this rule is to prevent taxpayers from generating artificial tax losses while maintaining essentially the same investment position.

For CPA REG candidates, the wash sale rule appears frequently in questions involving individual taxation and investment transactions. Understanding the mechanics of the disallowed loss and the basis adjustment is essential.

Key Elements of the Wash Sale Rule

The 61-Day Window

The wash sale period covers 61 days total: 30 days before the date of sale, the date of sale itself, and 30 days after the date of sale. If the taxpayer acquires substantially identical stock or securities at any point within this window, the loss on the sale is disallowed. The acquisition can be through a direct purchase, an option exercise, an IRA contribution, a dividend reinvestment plan, or a short sale settlement.

Substantially Identical Securities

The term "substantially identical" is critical. Stocks and bonds of different corporations are generally not substantially identical. However, preferred stock convertible into common stock of the same company may be considered substantially identical to that common stock. Mutual funds tracking the same index from different fund families are generally not considered substantially identical, though the IRS has not issued definitive guidance on this point.

Options on the same stock may also trigger wash sale treatment. Acquiring a call option or writing a put option on the same stock within the wash sale window can cause the loss disallowance. Bonds of the same issuer with significantly different maturity dates, interest rates, or other terms are generally not substantially identical.

Disallowed Loss and Basis Adjustment

When a wash sale occurs, the disallowed loss is not permanently lost. Instead, it is added to the basis of the replacement security. This adjusted basis ensures that the disallowed loss is eventually recognized when the replacement security is ultimately sold (outside the wash sale window).

The holding period of the original security also tacks onto the holding period of the replacement security. This means the time the taxpayer held the original shares counts toward determining whether gain or loss on the replacement shares is short-term or long-term.

Calculation Example

A taxpayer buys 100 shares of XYZ Corp for $5,000. On March 15, the taxpayer sells all 100 shares for $3,500, realizing a $1,500 loss. On April 1 (within 30 days), the taxpayer buys 100 shares of XYZ Corp for $3,800. The $1,500 loss is disallowed under the wash sale rule. The basis of the new shares becomes $5,300 ($3,800 purchase price + $1,500 disallowed loss). If the taxpayer later sells these shares for $6,000, the gain is only $700 ($6,000 - $5,300).

Partial Wash Sales

If a taxpayer sells 200 shares at a loss but only repurchases 100 shares within the wash sale window, the wash sale rule applies only to the portion covered by the replacement purchase. The loss on 100 shares is disallowed and added to the basis of the 100 replacement shares, while the loss on the other 100 shares is recognized.

Important Limitations and Exceptions

• Applies only to losses: The wash sale rule does not apply to gains. A taxpayer can sell at a gain and immediately repurchase without restriction.
• Individual taxpayers and entities: The rule applies to individuals and certain other taxpayers. Dealers in securities may be exempt for securities held as inventory.
• IRAs and related accounts: If stock is sold at a loss in a taxable account and substantially identical stock is purchased in an IRA within the wash sale window, the loss is permanently disallowed. Unlike a regular wash sale, the basis adjustment does not apply because IRA transactions are not tracked on an after-tax basis.
• Spousal accounts: Purchases by a spouse in a jointly filed return can trigger wash sale treatment.

CPA Exam Tips

• Count the 61-day window carefully: 30 days before + sale date + 30 days after.
• Remember that disallowed loss is added to the basis of replacement shares, not permanently lost.
• Watch for IRA repurchases, which cause permanent loss disallowance.
• Partial wash sales require proportional calculation.
• The holding period of the old shares tacks onto the new shares.