Here’s What Happens During a Wash Sale

The assets you have in your brokerage account are there to help you make money. But making money can be a mixed bag, because when you end up with gains in a brokerage account, they can result in a tax liability for you.

It's therefore pretty common for investors to strategically sell stocks at a loss to offset gains. In fact, not only can you use a loss like that to offset capital gains, but you can use up to $3,000 in investment losses per year to offset ordinary income.

But there are rules you'll need to follow if you're selling stocks or other assets in order to benefit from a tax standpoint. And if you're not mindful of your timing, you might lose out on a tax break you'd otherwise be entitled to.

Beware the wash sale rule

Let's say you just sold a stock in your portfolio at a $2,000 profit. You may be inclined to then sell a different stock at a $2,000 loss to offset that $2,000 gain.

That's something you're absolutely allowed to do. What you can't do, however, is re-buy that same stock within 30 days. Similarly, you can't have bought shares of that stock up to 30 days prior to your sale date. If you go this route, it's called a wash sale, and that means you don't get to claim your $2,000 loss for tax purposes.

In a nutshell, the logic here is that if you're going to claim an investment loss for tax purposes, it needs to be an actual loss. If you sell shares of a stock at a $2,000 loss but then replace them that same month, you're not really liquidating that position -- at least not in the eyes of the IRS.

So basically, if you want to avoid a wash sale, don't sell a stock for tax purposes and then buy the same one within 61 days of that sale. That means you can't buy shares of that same stock 30 days before your sale and 30 days after.

You should also know that wash sale rules apply to not just individual stocks, but also assets like mutual funds and exchange traded funds (ETFs). Things can get a little tricky there, because the wash sale rules state that you can't sell an asset at a loss and replace it with one that's substantially identical.

So if you unload shares of an energy ETF and replace them with shares of a different energy ETF, it's questionable as to whether you'll trigger the wash sale rule. But you might, by virtue of swapping one investment for another that's extremely similar.

How to avoid a wash sale

Being mindful of your timing when buying and selling investments could help you avoid a wash sale. So if you sell shares of Target at a loss and you haven't bought any in the 30-day period leading up to that sale, you can steer clear of a wash sale by waiting a full 30 days to buy more shares of Target.

You can also potentially avoid a wash sale by replacing individual stocks with ETFs. Let's say you sell shares of Chevron, a major energy company, at a loss, and then buy shares of an energy ETF that includes Chevron within 30 days. You may be able to argue that you didn't replace your sold shares with a substantially identical investment, since your energy ETF might consist of dozens of energy companies.

All told, if you're not sure whether you're at risk of a wash sale, it's a good idea to consult an accountant. If you have a financial advisor you work with, you can ask them as well. There are some gray areas when it comes to wash sale rules, and a professional will likely be in a better position to help you navigate them.