January 3, 2008 12:00 am

New Trap in the Wash Sale Rule

The wash sale rule in the tax law prevents you from recognizing the economic loss you've experienced on the sale of securities when you reacquire substantially identical securities within 30 days before or after the date of sale. But what if you sell securities in your personal investment portfolio and then buy the same ones in your IRA or Roth IRA within the wash sale period? Professionals have debated the answer for years; now the IRS has spoken.

Indirect repurchases

Let's say that you purchased XYZ stock several years ago for $1,000, but it's worth $600 today. You sell the stock and the next day you cause your IRA to purchase it for $600 because you believe in the long-term performance of the stock. According to the IRS, even though an IRA is a tax-exempt trust, you, the owner of that trust, are treated as having acquired the securities. Thus, you cannot take the $400 loss.

The IRS reasoning is that even though the IRA is a trust, a separate taxpayer which is managed by a trustee or custodian, you are still the owner of the account. IRAs cannot be used to circumvent the wash sale rule (you cannot do indirectly what you are barred from doing directly).

Added penalty

Usually, the wash sale rule is merely a timing issue-you can't take the loss currently, but the economic loss is preserved. The basis of the securities you acquire is the basis of the old securities, increased by the excess of the selling price of the old securities over the purchase price of the new securities. This will enable you to take a greater loss (or minimize gain) on a future sale of the acquired securities.

The IRS says you cannot increase the basis of the securities acquired by the IRA in this situation. So the initial loss is gone forever.

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Tax Glossary

Straddle

Taking an offsetting investment position to reduce the risk of loss in a similar investment.

More terms