Wash Sale Rule Purpose

[sengsational]

I never really thought about it, but what evil is supposed to be prevented by not allowing someone to realize a loss on an investment? Don't they even have a rule for mutual funds that compel them to keep unrealized capital gains from getting too big?

If you were talking about a privately held stock where the price could be manipulated down, even though the higher true value could be used for the eventual final sale,, it would seem that the full brunt of the taxes would be assessed.

I'll admit to having done zero research on this (I'll be down to almost no investable after tax funds soon, so impact on me), but am genuinely curious what mischief is possible, and how much more advantage can be had through buying the exact same stock vs a similar one.

 

[ERD50]

I think it is just a simple matter of they want to collect the taxes on gains now, rather than later. The wash sale prevents people from doing really simple things (sell, then buy back a minute later) to offset other gains, and lower their taxes for the year.

But in the end, it is a wash - you will pay those taxes later. But the more you can play, the more you can, over time, keep yourself in a lower bracket (avoid really big gains in any one year). Plus, more gains could get lost forever as a step up at the holder's death.

-ERD50

 

[Texas Proud]

I think it is a bit different than what ERD50 says....

It prevents ALL losses from becoming ST losses... IOW, when the year of holding the stock is coming to an end, you have to ask if you want to continue to hold thinking the stock is still a good investment or selling it to book the loss but knowing you cannot buy it for 30 days...

If there were no wash rules, a simple sell and buy and you book that ST loss...


AFAIK, there is no rule of how much gain a fund can keep... I know a few of the Vanguard funds that have huge unrealized cap gains.... I just looked up one of the tax managed funds and it has unrealized gain at 50% of the fund...

 

[MooreBonds]

I think it is a bit different than what ERD50 says....

It prevents ALL losses from becoming ST losses... IOW, when the year of holding the stock is coming to an end, you have to ask if you want to continue to hold thinking the stock is still a good investment or selling it to book the loss but knowing you cannot buy it for 30 days...

If there were no wash rules, a simple sell and buy and you book that ST loss...

I don't know the specific history, but I would think it's more along the lines of ERD50's explanation.

If you had $x in gains in 2016, everyone would simply sell all losing positions to wipe out the gains in 2016, and you would have net zero taxable gains. Then they would buy them right back 1 second later to re-establish the position.

Sure, it would defer the gains to later years when you ultimately sell them....but if you held them long enough, you get the stepped-up basis upon death. So it would effectively allow you to defer gains to whatever future year you wanted to, and deprive the government of current year tax revenue.

There are limits to your 401k plans to prevent you from diverting ALL of your income to a 401k, since it would deprive the gov't of tax revenue in the current year. Sure, they would eventually get the taxes when you withdraw from a 401k down the road, but they do need some revenue this year, which is why they limit the contribution amounts.

By instituting the 30 day requirement, it makes you stop and think if you really want to risk the gamble of the position changing in price over the next 30 days in order for your to take the loss and offset your gains. If there were no 30 day minimum requirement, then everyone would simply sell all losers and buy them right back to create losses whenever they want.

 

[Texas Proud]

I still think that I am closer to the real reason.... I have not found any reference to using these losses to offset other gains...


From wiki...

The regulations around wash sales are to protect against an investor who holds an unrealized loss and wishes to make it claimable as a tax deduction within the current tax year. The security is then repurchased in the hope that it will recover its previous value, which would only become taxable in some future tax year.

​

And here is from another site with the history of the law....

History of Wash Sale Rule

Congress has had the legal authority to tax income of both individuals and corporations since 1913, when the 16th amendment to the U.S. Constitution made income tax permanent. Since then, Congress has attempted to encourage economic growth and thus increase tax revenue collection through key pieces of legislation. One example is the Revenue Act of 1921, which introduced the wash sale rule — one of the first tax shelters to be disallowed by Congress. Spearheaded by Andrew Mellon, the Secretary of the Treasury, the Revenue Act of 1921 was put in place as a way to spur economic activity after World War I. The Act set the groundwork for key aspects of our current system of taxation. It differentiated taxation of capital gains (the profit from buying and selling capital assets (investments and property)) from ordinary income. In an attempt to increase tax revenue collection, the Act created the wash sale rule as a way to stop sophisticated investors and taxpayers from committing tax fraud and creating securities transactions to lower their tax liabilities.
​

 

[Gone4Good]

I don't know the specific history, but I would think it's more along the lines of ERD50's explanation.

I still think that I am closer to the real reason....

I'd side with ERD50 and More Bonds with the added acknowledgment that Texas Proud isn't exactly wrong.

The key thing that separates the two is the understanding that capital losses are really only valuable as offsets to taxable gains. Sure, you can claim some small portion of your current capital losses against ordinary income (I'd have to look up the exact $ amount but I'm thinking it's less than $5K per year.) But that's it, and then you'd have to carry forward the balance of your loss to a future period.

So the wash sale restriction really prevents both transactions described above. But the biggest impact it has is to prevent large phantom losses from eliminating large current taxable gains. It's true that it also limits the ability to take losses without offsetting gains, but that is already specifically limited in size by a different tax rule.

So on balance, both sides are right, but ERD50's rationale fixes a much bigger tax dodge and therefore stands as the most likely motivator for the rule.

 

[Onward]

It's to prevent you from deducting losses while keeping your position in the stock--i.e. eating your cake and having it too.

 

[sengsational]

Thanks all. I think I've got a better idea about it now.

The point about step up in basis at death is a legitimate concern for the tax collectors, since allowing wash sales would allow shifting losses earlier and delaying showing gains, maybe not showing them at all if the step up happens. It's not like there's no step up if wash sales are allowed, it's just bigger if some losses could be shifted to earlier.

I just wonder if things are the same now as they were in 1921 and if it makes as much sense now as it did then. Back then, I couldn't use automation to find another stock with 99% correlation and buy that for 30 days. Or use futures to insure against the price going against me while out for 30 days.

And back then, maybe public stock price manipulation was probably easier, so easier to play games with shifting gains off to the future. I could get up to some real fancy stuff...sell my $100 stock to my BIL for $1 with the agreement he'd sell it back to me for $1, locking-in a $99 loss. With games (fraud) like that, you could put off capital gains until you wanted. Of course you'd get slammed when you needed the money (if you didn't take a dirt nap before then).

 

[ownyourfuture]

This might be a little 'out there', but I always thought the following was at least part of the reason for wash sale rules.

This isn't something that I read or heard from anyone else, it's just a theory I have.

Let's take John Doe, an 'insider' @ XYZ corporation.
He's not a CEO, CFO, & he's not on the Board of Directors.

He is however, an employee who has access to up-to-the minute sales figures etc

The company has had a really bad 4 years, & therefore the stock price is very low. He can see that things are really turning around now, & when the company reports earnings in 4 weeks, it will absolutely blow out the estimates, & the stock will probably skyrocket.

He has 2,000 shares with an average cost basis of $16.00
With the stock now trading @ $10.00, he could sell all 2,000 shares, then turn around & buy 2k @ $10.00

I'll reiterate that this guy isn't a 'big shot' in the company, & therefore not someone who would attract as much attention from the SEC as a CEO, CFO, or BOD member.

((((Insider trading on a small scale))))

Again, just a theory

 

[Dash man]

This might be a little 'out there', but I always thought the following was at least part of the reason for wash sale rules.



This isn't something that I read or heard from anyone else, it's just a theory I have.



Let's take John Doe, an 'insider' @ XYZ corporation.

He's not a CEO, CFO, & he's not on the Board of Directors.



He is however, an employee who has access to up-to-the minute sales figures etc



The company has had a really bad 4 years, & therefore the stock price is very low. He can see that things are really turning around now, & when the company reports earnings in 4 weeks, it will absolutely blow out the estimates, & the stock will probably skyrocket.



He has 2,000 shares with an average cost basis of $16.00

With the stock now trading @ $10.00, he could sell all 2,000 shares, then turn around & buy 2k @ $10.00



I'll reiterate that this guy isn't a 'big shot' in the company, & therefore not someone who would attract as much attention from the SEC as a CEO, CFO, or BOD member.



((((Insider trading on a small scale))))



Again, just a theory

Any employee with that kind of information is locked out of trading for a month before an earnings announcement until a few days after the announcement where the public has time to digest the information. If they do trade they could be investigated for insider trading. My DW is one of those type of employees.


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[ownyourfuture]

Thanks for the reply Dash man

 

[heeyy_joe]

Eventually it all comes out in the wash.

 

[mpeirce]

Any employee with that kind of information is locked out of trading for a month before an earnings announcement until a few days after the announcement where the public has time to digest the information. If they do trade they could be investigated for insider trading. My DW is one of those type of employees.

At my last company, there was a calendar that showed when not to trade. It was mandatory for directors and above. For the rest of us it was "recommended" since many of us knew about "secrets" that might move the stock.

 

[sengsational]

In one of my jobs, I had insider information on product releases. It was supposed to be really big news, tons more revenue, blah, blah. I'm glad I didn't trade on that info because the stock dropped on the day of the announcement, hehe!

Eventually it all comes out in the wash.

I see what you did there

But really, it does (come out in the wash). Presuming he doesn't let the tax tail wag the profit dog, and doesn't hold 'till he dies, the guy will eventually have to pay the gains on anything more than the $10, essentially shifting income into the future. That might actually be a GOOD thing for the IRS if tax rates go up between now and then.