Ordinarily, losses on stocks can be used to offset gains and thus lower tax liability. A major exception to this, however, is the Internal Revenue Service (IRS) "wash sale" rule. The purpose is to prevent fraudulent reporting of transactions that don't truly represent a loss to the investor. For high frequency traders, though, the wash rule can make it difficult to report losses in actively traded names. The wash rule applies whenever the purchase and sale of shares in a single stock occur within 30 days.
Calculate loss. When stock is sold at a loss, the amount of the loss is the cost of the stock less the proceeds of the sale. If only a portion of the stock is sold, then the corresponding proportion of the initial cost is used. For example, if 100 shares were purchased at $2 each and 50 shares were subsequently sold for $1, the loss is $50 (50x2 - 50x1 = 50).
Identify 30-day window. The 30-day applicability of the wash rule applies both prior to and subsequent of a sale. So, if the shares in the example given in the previous step were sold less than 30 days from the date of original purchase, the $50 could not be deducted because it would count as the disallowed loss of a wash sale. If the 100-share position was acquired through multiple purchases, only some of which occurred within the 30-day window, then only the loss on those shares purchased in the window would classify as a disallowed loss.
Identify losses applied to new purchases. If shares of the same company are purchased within 30-days after the sale, the loss becomes a wash to the extent of the new purchase. Using the same example, if a new 50 shares are purchased within 30 days, then the entire loss on the 50 share sale is a wash. If only 10 new shares are purchased, then only the loss on 10 shares is a wash, and the loss on the remaining 40 is deductible.
Add wash proceeds to cost basis. Whenever a wash sale occurs according to the 30-day rule, the amount of the loss is applied to the cost basis of the remaining shares. Assuming that the entire $50 loss in the initial example is a wash sale, the remaining 50 shares, which were originally purchased at $2, would now have a total cost basis of $150 (2x50 + 50).
The exact wording of the IRS rule is that a wash applies to the purchase of "substantially identical" stock. Shares of different companies are not usually considered substantially identical, nor are preferred and common shares of the same company, unless the preferred shares are fully convertible into common stock, have identical voting rights, and subject to the same dividend restrictions.
Just because the proceeds of a wash sale cannot be deducted as a loss for tax purposes, they should still be reported on Form 1040 Schedule D. The appropriate way to do this is to make an offsetting entry described as "wash sale" in the amount of the disallowed loss.