How to Report Superficial Loss on a Tax Return

Selling an investment at a loss and then repurchasing the same or a similar one shortly after can lead to a surprise at tax time: the loss you thought you could claim is disallowed. In the U.S. tax code, this is governed by the wash sale rule, a frequent source of confusion for investors and a critical detail for tax preparers to get right. This article provides a clear guide on how to identify a wash sale, calculate its impact on cost basis, and correctly report it on your tax return.

What Exactly is the Wash Sale Rule?

The wash sale rule, found in Internal Revenue Code (IRC) Section 1091, prevents a taxpayer from claiming a capital loss on the sale of a security if they acquire a “substantially identical” security within a 61-day period. The purpose is straightforward: to stop taxpayers from harvesting tax losses on investments they essentially still own, a practice that creates an artificial loss without any real change in their economic position.

This rule is the U.S. equivalent of what is known as the "superficial loss" rule in other countries, such as Canada. While the names differ, the core principle is the same. The key to navigating this rule is understanding its three main components: the 61-day window, the definition of "substantially identical," and the proper reporting procedure.

Understanding the 61-Day Wash Sale Window

The period covered by the wash sale rule is a total of 61 days. This isn't just the 30 days after the sale; it also includes the 30 days before the sale. The full window is:

• 30 days before the sale that created the loss
• The day of the sale itself
• 30 days after the sale

If you purchase a substantially identical security at any point during this 61-day timeframe, any loss from the sale is disallowed for the current tax year. The most common mistake is forgetting that activity before the sale also counts.

Example:

Imagine you sell 100 shares of XYZ Corp. at a loss on October 15th. The wash sale window runs from September 15th (30 days before) to November 14th (30 days after). If you buy more XYZ Corp. shares on any day within this period, the loss on your October 15th sale will be subject to the wash sale rule.

What Does "Substantially Identical" Mean?

This is where things can get tricky. "Substantially identical" is not strictly defined in the tax code, but IRS guidance and court rulings have established some clear lines.

• Stocks and Bonds: The stock of one company is generally not identical to the stock of another, even if they are in the same industry. However, different classes of stock of the same company might be considered identical if they have similar rights. Bonds are generally considered identical if they have the same issuer, coupon rate, and maturity date.
• Options: An option to acquire a stock is considered substantially identical to the stock itself. Buying a call option on XYZ Corp. within the 61-day window will trigger the wash sale rule if you sell XYZ Corp. stock at a loss.
• ETFs and Mutual Funds: This is a gray area. Two S&P 500 index funds from different companies (e.g., Vanguard and Schwab) tracking the same index may be considered substantially identical by the IRS. It's often best to advise clients to be cautious here and repurchase an ETF or fund tracking a different, though similar, index.

How to Report a Wash Sale: A Step-by-Step Guide

The good news is that the disallowed loss isn't gone forever — it's deferred. The disallowed amount is added to the cost basis of the new, replacement shares. This reduces the future capital gain (or increases the capital loss) when you eventually sell the new shares. Here is how to handle a wash sale on a tax return.

Step 1: Identify the Wash Sale on Form 1099-B

Most brokerage firms will track wash sales for you and report them on Form 1099-B, "Proceeds from Broker and Barter Exchange Transactions". You will often see:

• Box 1e: Cost or Other Basis. The reported basis may or may not be adjusted for the wash sale, so always check the details.
• A specific code: Brokerages typically use code "W" to flag the transaction as a wash sale.
• Box 1g: Wash Sale Loss Disallowed. This box will show the amount of the loss that you are not allowed to claim.

While brokers do a decent job tracking this within a single account, they cannot track activity across different financial institutions. The final responsibility for correctly reporting wash sales falls on the taxpayer and their preparer.

Step 2: Complete IRS Form 8949

Form 8949, "Sales and Other Dispositions of Capital Assets", is where the transaction is officially reported to the IRS. Here's how to fill it out:

First, you report the sale transaction as it occurred:

• (c) Date sold or disposed: The date of the sale that generated the loss.
• (d) Proceeds: The amount received from the sale.
• (e) Cost basis: The original purchase price.

Then, you apply the wash sale adjustment:

• (f) Code(s) from instructions: Enter code W here.
• (g) Amount of adjustment: Enter the amount of the disallowed loss from the wash sale as a positive number. This adjustment will increase the loss, bringing the net result to zero (or to a smaller amount if it's a partial wash sale).

By entering the disallowed loss in column (g), you are effectively canceling out the loss for tax purposes on this specific transaction.

Step 3: Calculate the New Cost Basis

This is the most critical step for ensuring you receive the tax benefit in the future. The disallowed loss is added to the cost basis of the replacement shares.

Example:

1. Buy 100 shares of XYZ at $50/share (Total cost: $5,000).
2. Sell all 100 shares at $40/share (Total proceeds: $4,000). This creates a $1,000 loss.
3. Within 30 days, buy 100 shares of XYZ back at $42/share (Total cost: $4,200).

Applying the rules:

• The $1,000 loss is a wash sale and is disallowed. On Form 8949, you will report the loss and adjust it by $1,000 using code 'W'.
• The new cost basis for the replacement shares is calculated as: Purchase price of new shares + Disallowed loss.
• New Basis = $4,200 + $1,000 = $5,200.
• The holding period for the new shares also includes the holding period of the original shares you sold.

The totals from Form 8949 will then flow to Schedule D, "Capital Gains and Losses", reflecting the correct net gain or loss.

What About Tax Software?

Software like TurboTax for individual filers or professional-grade tools like Drake Tax can often handle these calculations automatically, especially when importing 1099-B data directly from a brokerage. However, as a practitioner, you must be prepared to verify the software’s work and manually intervene, particularly when trades happen across multiple accounts or brokers.

Common Wash Sale Traps to Avoid

Several frequent scenarios can catch taxpayers by surprise. As an advisor, knowing these pitfalls is key.

• Wash Sales In an IRA: This is the most dangerous trap. If you sell a security at a loss in a taxable brokerage account and then repurchase a substantially identical security in an IRA (or other tax-sheltered account) within the 61-day window, the loss is disallowed permanently. Because you can't adjust the cost basis of assets inside an IRA, the disallowed loss is never recovered.
• Partial Wash Sales: If you sell 100 shares at a loss but only buy back 50 replacement shares, only the loss associated with those 50 shares is disallowed. The loss on the other 50 shares can be claimed. The calculation must be done on a share-for-share basis.
• "Buying" Without Meaning To: Remember that acquiring a stock via dividend reinvestment plans (DRIPs) counts as a purchase. If a client sells shares at a loss shortly before a dividend is reinvested, it can inadvertently trigger a wash sale.

Final Thoughts

The wash sale rule isn't designed to take away your tax deduction but to defer it until you have truly exited your investment position. The key to handling it correctly lies in vigilant record-keeping, a firm understanding of the 61-day window, and accurately adjusting the cost basis of repurchased shares on Form 8949.

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