A wash sale is a form of tax avoidance in which an investor sells a security at a loss and then repurchches it again within 30 days of the sale. The investor is then not allowed to deduct the loss on their taxes. The U.S. Internal Revenue Service (IRS) has implemented the wash sale rule to ensure investors do not use this practice with the intention of reducing their tax liabilities.

Whenever an investor sells a security for a loss, the loss can be used to offset capital gains from other investments in the same tax year. The wash sale rule eliminates this potential benefit by preventing the deduction of losses from the sale of a security if the same (or a substantially similar) security is purchased within 30 days of the sale, either before or after. This period is often referred to as a ‘ wash sale restriction period’. The rule does not apply to gains, however; an investor can sell a security for a profit and repurchase it within the restriction period without any concern.

If an investor fails to comply with the wash sale rule, their loss deduction is disallowed. Furthermore, the disallowed loss is added to the cost basis of the repurchased security and the overall taxable gain or loss when the security is sold again is recalculated. Essentially, the investor will have to pay more taxes on the sale than they originally planned as a result of their wash sale violation.

The wash sale rule applies to both taxable (regular) and tax-advantaged accounts, like Individual Retirement Accounts (IRAs). Short-term trading strategies, like day trading, typically require investors to repurchase a security shortly after selling it, and the rule should always be taken into consideration to prevent the potential for a disallowed loss occurring. Furthermore, if an investor’s taxable and tax-advantaged accounts are linked, the wash sale rule may extend beyond the accounts and prevent the deduction of losses.

Ultimately, the wash sale rule requires investors to consider more than just the current tax implications of a sale before executing an investment transaction. Furthermore, the rule is an important reminder to always understand the potential tax treatment of an investment before executing any transactions.