The Wash-Sale Rule officially states that an investor cannot claim any loss on the sale of a security if a substantially identical security was bought within the thirty working days prior to the sale or thirty working days following the sale. Put simply, the IRS wants to ensure that investors cannot claim a capital loss on an investment when they did not truly incur a loss.

The Wash-Sale Rule applies to both long and short-term investments. Long-term investments are usually held for one or more years while short-term investments are typically held for less than one year. It is important to note that the Wash-Sale Rule doesn’t only apply to stocks and bonds, but to all securities, including mutual funds and derivatives.

The purpose of the Wash-Sale Rule is to prevent fraud. The IRS does not want investors to be able to use losses for tax breaks when the losses actually do not exist. The rule does not outright forbid you from trading a security prior to or following a loss but it does restrict the deductibility of any losses if you do. By disallowing unreasonably book losses, the IRS can eliminate any unjustified tax deductions in the current period.

Let’s look at an example of a wash sale scenario. Suppose an investor buys 100 shares of ABC stock for $10 and then the stock drops to $5. If the investor sells their shares at the lower price and buys 100 more shares of the same stock within the 30 days after the sale (or between 61 days, including the first 30 day period), they have effectively triggered the Wash-Sale Rule. As a result, the investor will not be able to claim a capital loss on the sale of their ABC stock and the total amount of their capital loss will be reduced to avoid an incorrect tax deduction.

In order to avoid triggering the Wash-Sale Rule, investors must be vigilant about their trades. If there is a substantial similarity between the assets, then it is likely that the IRS will consider the security to be a “wash sale”. Investors should be aware of this when investing and take note of any trades that may have caused a wash sale.

In conclusion, Wash-Sale Rule exists to make sure that investors are not able to artificially create losses for tax breaks. It applies to all security investments, including stocks, bonds, mutual funds, and derivatives. It is important to be aware of wash sale scenarios and avoid triggering the rule in order to maintain correct losses and deductions.