It's the end of the year, time to think about nasty stuff such as wash sales, mark-to-market and Section 1256. This article reprises one written last spring, but I thought I would move the discussion up a few months. I also thought I'd break the discussion up over several weeks.
Before I get started with the discussion, it's important to note that I'm not a tax professional. The purpose of this article and the ones that follow are to pinpoint areas you might need to discuss with your own tax professional. I cannot guarantee that the information I'm providing is up-to-date or correct, although I've course made every effort to ensure that it is.
The reason I'm writing sooner is related to wash sales. Wash sales can make reporting our trades a miserable task. As I noted in last year's article, it turns out that if you sell and take a loss in a stock or an option and then buy back "substantially identical stock or securities" within 30 days, you can't take that loss (IRS Section 1091. Loss from wash sales of stock or securities). Instead, that loss must be rolled into the cost basis for the repurchase. One website warns that the phrase "substantially identical" might apply not only if you were buying the same stock after selling it for a loss within 30 days, but also if you were buying the stock of an acquiring company within 30 days of taking a loss in the stock of the acquired company, for example. Don't think you can get your wife or husband to buy back the stock, either. The government likely counts that as a wash sale, too, some tax-related sites warn. Ditto buying it back through your company if you control the company.
One ticklish little problem exists. What happens if you take a loss in a security in a regular, taxable account, but then buy back a substantially identical security in your IRA account within 30 days? You're not required to report trades in your IRA to the IRS, so is this meet wash-sale requirements? Opinions differ. A writer for Fairmark.com, a source of much information about trading-related tax rules, argues that the wash-sale rules would apply. Even that author notes, however, that an IRS agent, when replying to a similar question, answered that it was acceptable to buy replacement shares in an IRA.
You're certainly going to have to consult a tax professional on this one, but according to Kaye A. Thomas, the author of the article mentioned, you're probably going to get a different answer from each tax professional you consult. Obviously, it's impossible for me to weigh the various opinions and draw a conclusion when tax professionals differ in their opinions.
If you're an active trader, the wash-sale rule can cause big headaches, especially if you tend to trade in and out of the same securities and if you occasionally go through periods when you're experiencing losses. If you're not occasionally going through periods when you're experiencing losses, you're a genius and you won't have a bit of trouble calculating those wash sales.
For the rest of us, even the mathematically inclined, the calculations can result in lots of hair pulling. For example, imagine that you like to swing trade the QQQQ's. You owned 1000 shares but were stopped out for a loss. On day 2 after that, you bought back QQQQ, but you weren't feeling particularly confident, so bought back only 300 shares. You lucked out and sold those for a gain. Then, on day 4, with that winning trade behind you, you bought back 1000 more shares, but sold them at a loss that same day when QQQQ headed down instead of up. You folded 7/10 (700/1000) of the original loss into the cost basis from the day 4 purchase. When you're ready to buy 500 shares of QQQQ again on day 5, you will have to fold 1/2 (500/1000) of the day 4 losses into the purchase of the 500 shares. Your schedule D will branch out like the most complicated of family trees.
Don't panic. The wash sale rule doesn't mean that you can never account for that loss or never quit folding it into future trades. Of course you can: you just have to wait thirty days before you buy that security back again. Also, some special rules apply to options on broad-based indices, so hang on for the next article in a week or two before you panic if that's what you trade.
The wash-sale rule can wreck havoc on your taxes. Perhaps your account value is down for the year, but you had some spectacular gains at the first of the year, only to suffer losses toward the end of the year that wiped out all your previous gains and then some. If you've traded in and out of that security in which you experienced the end-of-year losses through the end of the year and into the next year, you could owe unexpected taxes. You can't yet count some of the losses that are still being folded into repurchases of the same security. That means that you can't subtract them from the big gains you had earlier in the year. Unless your trades meet some special qualifications to be discussed in a future article, you could be paying taxes on more gains that your account balance says you've had for the year.
Oh, but you trade options, you're thinking, and you're always buying options with different strikes and expiration periods. You might be buying a call or a put. You're safe.
Not so quick. Remember that "substantially identical" clause from the IRS code quoted above? Legal interpretations and other language clarify that "substantially identical" clause. Options traders aren't going to be happy with the clarification. It doesn't matter what strike you're buying, what expiration your option has: the wash-sale rules apply if you're dealing with options on the same underlying. One day, you can buy an ATM current-month option on GOOG and take a loss, and then 15 days later, you can buy a deep ITM option two months out on GOOG, and you're going to have to fold that original loss into the cost basis for the second option purchase. The same is true if one day you're buying actual GOOG stock and taking a loss and the next week you're buying GOOG options. They're still considered "substantially identical."
We options traders need to have a talk with the IRS, don't we? We know that buying an ATM option and one deep ITM with different expiration periods is not a "substantially identical" purchase. Neither is going long a call and selling a credit spread. Neither is day trading a stock's options and owning the stock. The original purpose of the wash-sale rule was to prevent investors from taking a loss in a stock that they really intended to maintain a position in all along. We options traders know that when we're day trading options, we rarely have any intention of owning anything. One exception could be when you take an option position with the intention of owning the stock at a lower price, such as selling a put on a stock you really want to own, but at a lower price. Another exception could be when you sell a covered call against a stock you own and want to continue owning, to give you some downside protection or bring in some extra income.
For most active options traders, however, there's no intention to own anything. We're doing the same thing a retailer does, trying to move goods and benefit from the transaction. Retailers don't intend to own the goods in their stores, and, most times, options traders don't intend to, either. I suspect nothing good would come of trying to argue that point with the IRS with the goal of someday getting them to change the rules, and, for now, most options trades fall under wash-sale accounting rules. We'll discuss exceptions in a future article.
Are you weeping tears of frustration at the thought of making all those computations? Dry your tears. Search around and you can find software that performs the calculations. One is TradeLog. GainsKeeper is another software that reportedly automates wash-sale calculations and downloads them directly into the account. I haven't tried GainsKeeper for this purpose because when I first tried using them as a trading log many, many years ago, they weren't yet set up to handle options trades. Not having used them since, I haven't investigated whether the software makes smooth wash-sale calculations for options as well as stocks, but you might check it out if you're interested.
Some have used Turbo-Tax (R), but last year some traders were reporting that Turbo-Tax's (R) wash-sale computations didn't tend to work when traders were buying and selling different amounts of stock or options contracts. As I noted in last spring's article, I haven't tried the software or verified that problem for myself, so check it out before you take my word for it.
In fact, as I said earlier, I'm not an accountant or a tax professional, so you shouldn't take my word for anything written here. This article should be considered only fodder for further research.
Another way of performing the wash-sale computations is to let your accountant or tax professional make them for you. The problem is that not all accountants or tax professionals know about wash sales. If you're using an accountant or tax professional to prepare your returns, make sure that person understands how to account for these trades.
After you've used a software program to make these calculations, you might be able to export the forms directly into popular tax-preparation software such as Turbo-Tax (R). Last year, TradeLog's documentation warned that Turbo-Tax (R) might not be able to handle the complicated wash-sale calculations necessary for an active trader. I checked this week, and TradeLog at least was still offering a similar warning. TradeLog offered suggestions for dealing with this problem, but said that because the problem was Turbo-Tax's (R), there wasn't a true workaround. Again, this wasn't a problem I could verify.
I repeat: I'm not a tax professional. Although I've made every attempt to verify the information here, my interpretations may be erroneous, or recent code changes that I didn't find might impact the way wash sales are calculated. These are complicated rules, as the various interpretations of cross accounting between regular, taxable and IRA accounts show. Even tax professionals disagree. This article is meant to alert you to areas you should research and not to give tax advice I'm not qualified to give. Don't write me with questions that arise as a result of this article: consult your tax professional instead. Oh, and also consider going straight to the IRS publication on wash sales, found at this link: http://www.irs.gov/instructions/i1040sd/ch01.html#d0e440
Now that we've talked about ways to ease wash-sale computations, it's time to
talk about how to avoid them entirely, but that will have to wait until the next
article. If you can't wait and want to read the previous article, you can find
this link but remember that the information there related to last year's tax
code. I haven't fully researched any changes that might have been made in the
mark-to-market and Section 1256 rules.