Thursday, December 27, 2007

Winners and Losers II (Wash Sales)

"You never count your money,
When you're sittin' at the table,
There'll be time enough for countin',
When the dealing's done."
- Kenny Rogers ("The Gambler")

If you sell investments at a loss in a taxable investment account to offset gains for 2007, be aware of the wash sale rule. Basically, the wash sale rule says that if you buy an investment within 30 days before or 30 days after a sale of the same investment, any loss you realize on the sale will be disallowed. Let's review a simple example:

You own stock in XYZ Corp and you have an unrealized loss of $100 - e.g., if you sell the stock you will have a realized $100 loss. You sell the XYZ stock on December 28, 2007 so you can take the loss on your 2007 tax return. A week after you sell the stock you see a news story that leads you to believe XYZ stock is going up, maybe way up. You feel like a sucker for selling, so you buy XYZ stock again. You have just created a wash sale, and your loss on the original purchase of XYZ will be disallowed by the IRS. The wash sale rules will not apply if you buy XYZ stock on the 31st day after the sale of the original shares.

A wash sale is not the end of the world, but it catches many unaware investors. All it means is that you can't deduct the loss on the original purchase and sale of the same investment. And, if you buy back the investment you sold and it skyrockets, you probably won't care much about the loss being disallowed.

There are a couple of ways you can take your loss and eat it too, so to speak.

The wash sale rule applies to identical investments. You can't buy back XYZ stock within 30 days and deduct the loss, but you can maintain some exposure to XYZ or its industry while deducting the loss on your original purchase. You do this by either buying another stock in the same industry or sector as XYZ or by buying a mutual fund or exchange-traded fund that invests in the same industry or sector that may include XYZ as one of its holdings. In either case, you won't have perfect exposure to XYZ, but your tax loss will still be deductible.

As always, tax advice specific to your situation should be sought from a tax professional.

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