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What is a Wash Sale?
A wash Sale is a type of business deal where investors sell securities at a loss and repurchases it just to claim capital loss on taxes for that fiscal year. Securities that can be sold in a wash Sale include options, stocks and bonds. Investors use wash sale to increase tax benefits or claim capital loss. Investors with this goal sell a losing security only to repurchase it within 30 days of selling it. However, it is possible for an investor to sell a losing security but purchases another similar security (and not the same one he sold) within 30 days of the sale.
How Does a Wash Sale Work?
Investors use the capital loss incurred from a wash sale as an effective approach to counterbalance capital gains in order to claim capital loss or reduce the tax liability an investor faces. If an investor sells a losing security and purchases the same or similar security within 30 days, capital loss can be claimed on the loss incurred which will lessen capital gains tax. If the Internal Revenue Service considers the transaction as a wash sale, no tax benefits will be allowed. Also, tax loss can be disallowed if the security sold by an investor is purchased by the spouse. The implementation of a 30-day wash-sale rule by IRS has impact on the effectiveness of a wash sale, because no loss can be recognized by a taxpayer if the repurchase is made after 30 days. Although, securities that can be traded in a stock exchange market include options, bonds and stocks, the IRS does not see bonds and preferred stock as identical to a company's common stock Preferred stock can be identical to common stock only if it is convertible to common stock. In a wash sale, investors receive credits for the losses they occur in the sale. Losses incurred by investors in a wash sale are added to the cost basis of the repurchased security. This will increase the cost basis of the security and also reduce taxable gains. A 15% favorable tax rate on long-term capital gains can be enjoyed by an investor if the holding period of the wash sale security is added to that of the repurchased security.