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Wash sale rule

Lesson in Course: Investing basics (expert, 10min )

Our friends tell us to sell high and buy back low. What's the risk of frequent trading?

As we start investing, a common trap most emerging investors fall into is the urge to day-trade. Day trading is short-term buying and selling of the same stock or security. Day traders try to time the market and make money by capturing inefficiencies in the market (e.g. stock price dipped midday just to recover by the end of the day.)

Day trading is notoriously hard and it's where most people lose their money. Before we even consider day-trading, we need to understand a significant IRS rule. A Robinhood trader who did not know about this rule had racked up $800K in taxes owed on $45K worth of profit.

Tax trap

Wash sale rule

The wash sale rule is an Internal Revenue Service (IRS) regulation that prohibits us from claiming a capital loss by selling and purchasing either the same or similar securities within 30 days of the sale at a loss. 

For example, we buy 100 shares of XYZ stock on November 1 for $10,000. On December 15, the value of the 100 shares has declined to $7,000, so we sell the entire position to realize a capital loss of $3,000 for tax deduction purposes. On December 27 of the same year, we repurchase the 100 shares of XYZ stock. The initial loss will be not be allowed to be counted as a tax loss since we bought the shares back within 30 days.

Dangers of day trading

If we continuously buy and sell meme stocks like GME and AMC, the IRS only recognizes the money we make on our good trades and none of the money we lose on our bad trades for the year. 

For example, let's say we started trading with $100. 

  1. If we bought GME at $70 and sold at $150, we would have a realized gain of $80, and funds of $180.
  2. If we bought GME at $180 and sold at $150, we would have a realized loss of $30 and funds of $150.
  3. If we bought GME at $130 and sold at $90, we would have a realized loss of $40 and funds of $110.

While we only made $10, because of wash sale rules, the IRS expects us to pay taxes on $80 worth of gains. In the case of the Robinhood trader, multiply these results by thousands, and there is no way for him to get out of the $800K tax bill for 2020.

 

To avoid the wash-sale rule, we need to wait at least 31 days to repurchase what we sold. Otherwise, any losses booked will not help our taxes.

The video below goes more in-depth on the wash sale rule.

 

Glossary

What is wash sale rule?

An Internal Revenue Service (IRS) regulation that prohibits us from claiming a capital loss by selling and purchasing either the same or similar securities within 30 days of the sale at a loss. 

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