What is Wash Sale Rule?

For an investor, it is important to not only know about investment and trading strategies in the securities market but also be aware of the tax implications which may arise. Wash Sale Rule is one such tax implication which investors should be familiar with during their investing journey.

What is Wash Sale Rule in Stock Trading?

Before understanding the Wash Sale Rule, let’s discuss the meaning of a Wash Sale. Often, investors sell securities that have diminished in value and deploy the sales proceeds in an alternate investment . A Wash Sale is when an individual sells a security at a loss and within 30 days before or after such sale, repurchases a ‘substantially identical’ stock or security. Thus, the total period for a Wash Sale is 61 days which includes 30 days before the sale, the date of the sale and 30 days after the sale.

Suppose you buy 100 share of HDFC Bank at Rs. 1,200 per share in April. After six months, the price of HDFC Bank drops to Rs. 1,050. You decide to book the loss and sell 100 shares on 30th September. The loss from the sale of these shares is Rs. 15,000. Within a week from the sale of shares, the price of HDFC Bank falls further to Rs. 1,000 and you decide to repurchase the shares. In this case, the sale transaction would be termed as a Wash Sale. The Wash Sale period commences on 1st September and closes on 30th October. The Wash Sale Rule is attractive if substantially identical stock or security is purchased during the said period.

The Wash Sale Rule is a regulation set forth by the Internal Revenue Service (IRS) in the United States. It is a tax regulation that restricts an investor from tax benefits for a security sold in a Wash Sale transaction. The Wash Sale Rule will also be attractive if an individual sells a security and their spouse or a company controlled by the individual buys the substantially equivalent security within the specified timeframe. The Wash Sale Rule also applies to the sale of Options and Futures .

Furthermore, if the loss is disallowed due to the Wash Sale Rule, then the loss becomes the basis for the cost of the new stock. The amount of loss is added to the cost of the repurchased stock. In the above example, Rs. 15,000 will be added to the cost of the repurchased shares to calculate the tax liability.

Wash Sale Rule for gains

It is impertinent to note that Wash Sale Rule for gains does not exist. Thus, if an investor were to profit from the sale of a security and within 30 days were to buy identical securities, then the gain from the sale would be taxable.

Investors are required to use their best judgement to determine whether a particular security is substantially identical to another. The investor may consult a tax professional to ascertain the applicability of the rule wherever required.

An investor may avoid the Wash Sale Rule altogether by employing some simple techniques. The most obvious method to do so is to monitor the Wash Sale period and avoid repurchasing shares in the specified time frame. Another method may be to invest in a mutual fund or exchange-traded fund which is similar to the securities sold. At the end of the Wash Sale period, the mutual fund or ETF may be sold and then repurchased. However, this strategy may not replicate the initial position entirely and involves higher costs.

The Wash Sale Rule in India

In India, the Wash Sale Rule does not apply. Gains from trading in securities is subject to short-term capital gain or long-term capital gain depending upon the period of holding of the security. According to the Income Tax Act of 1961, long-term and short-term capital gain can be set off against long-term and short-term capital losses. Tax liability applies to the difference.

For example, an individual has earned a profit of Rs. 10,000 as well as incurred a loss of Rs. 4,000. In this case, the investor can set off the loss of Rs. 4,000 and is liable to pay tax on the balance Rs. 6,000.

The logic behind Wash Sale Rule

An investor may opt to sell an investment at loss to prevent the capital from eroding further. The price may fall further and the investor may find such reduced price attractive for investment. As a result, the investor may repurchase the security.

On the other hand, an investor may trigger a Wash Sale intentionally to reduce the amount of capital gain taxes to be paid to the government. The Wash Sale Rule prevents a taxpayer from claiming artificial losses to reduce the tax liability.

Examples of Wash Sale Rule

A trader buys 100 shares of HUL Limited at Rs. 2,400 per share. After a few months, he sells the shares at Rs. 3,200 per share and earns a profit of Rs. 80,000. Capital gain tax at the rate of 10% is levied i.e. Rs. 8,000 is liable to be paid on the profit earned.

Simultaneously, the trader holds 100 shares of TCS Limited at Rs. 3,500 per share. The current market price of the shares at Rs. 3,200 per share and so the notional loss is Rs. 30,000. If he/she books the loss, then the tax liability reduces by Rs. 3,000.

Hence, selling the shares to reduce tax liability is the crux of a Wash Sale.