When it comes to investing in equities, it becomes essential for an investor to not only know about trading and the stock market, but also the various other implications that can arise out of it. And so, a couple of concepts that you should be aware of as an investor are the wash sale and the wash sale rule. Here’s everything that you need to know about these unique concepts.
What is a wash sale?
Before moving on to the wash sale rule, let’s first try to understand what a wash sale actually is following,
When an investor sells a stock or any other security at a loss and then buys the same stock or security again within a period of 30 days before or after the date of the sale, then the transaction is termed as a wash sale.
Wash sale examples
Let’s take a look at a couple of wash sale examples to better understand this concept.
Assume that you buy a share of Infosys for around Rs. 900. And one year later, you see that the share price has dropped to Rs. 700. You decide to book a loss (of Rs. 200) by selling the share for Rs. 700. However, a week after the sale transaction, you again decide to buy a share of Infosys for around Rs. 650. In such a situation, the sale transaction that you made would then be termed as a wash sale.
Assume that you buy a futures contract of Infosys for around Rs. 900. For the purposes of this example, let’s also assume that the lot size of the futures contract is just 1 share. A week later, you find that the value of the futures contract has gone down to around Rs. 800. You decide to book a loss (of Rs. 100) by selling the futures contract and closing your open position. However, two weeks after the sale transaction, you again decide to buy the same futures contract of Infosys for around Rs. 700. In this situation, the ‘sale’ transaction that you made to close out your position would then be termed as a wash sale.
What is the logic behind a wash sale?
Now that you’ve understood the concept with the help of these two wash sale examples, let’s delve even deeper and try to understand why an investor would buy the same security again after booking a loss?
An investor might sell a loss-making stock or security to protect his investment capital from eroding further. And after a few trading sessions, he might feel that the current stock price is quite attractive and hard to pass up, which might lead him to buy the same stock or security once again. In such a scenario, the wash sale transaction is triggered inadvertently.
That said, an investor might also trigger a wash sale intentionally to reduce the amount of capital gain taxes to be paid to the government. This method of intentionally triggering a wash sale is also known as tax-loss harvesting.
Triggering a wash sale for tax-loss harvesting
When you earn a profit from the sale of a stock, it is termed as either a long-term capital gain or as a short-term capital gain depending on how long you hold the stock for before selling it. And according to the Income Tax Act, 1961, you can set-off your long-term or short-term capital gains with long-term or short-term capital losses and only pay the difference as tax to the government.
And so, investors might trigger a wash sale, wherein they intentionally sell off their loss-making stock to set-off the capital losses arising from such sale with their capital gains. By doing this simple exercise, they can reduce their tax liability significantly.
The wash sale rule
Technically, the wash sale rule is an Internal Revenue Service (IRS) regulation that applies only to the United States of America. According to the wash sale rule, an investor cannot use the loss arising out of a wash sale to set-off his capital gains and reduce his tax liability.
However, the wash sale rule is non-existent in India, meaning that Indian investors can use a wash sale for tax-loss harvesting purposes without any repercussions from the tax authorities.
Here’s an example of how you can use the wash sale in India.
Assume that you hold a share of Ashok Leyland. The share price has dropped from Rs. 100 (the price at which you bought) to around Rs. 60. You currently have an unrealized loss of around Rs. 40.
Simultaneously, you also hold a share of TCS. The share price of the TCS stock has risen from Rs. 2,000 (the price at which you bought) to around Rs. 2,100. You currently have an unrealized profit of around Rs. 100. You decide to sell this share for a Rs. 100 profit.
Now, the profit of Rs. 100 is the capital gain on which you’re required to pay tax. However, to reduce the tax impact, you also sell off the Ashok Leyland share that you had for Rs. 60. You’ve effectively made a loss of Rs. 40 on this transaction.
But then, you don’t actually wish to let go of the Ashok Leyland share. And so, you immediately buy the share of Ashok Leyland once again at around Rs. 60. Such a move ultimately triggers a wash sale transaction.
By setting off the loss of Rs. 40 against the profit of Rs. 100, your net capital gain would be just Rs. 60, on which you would be required to pay tax, thereby reducing your tax liability.
Since the wash sale rule is not present in India, you can make use of this kind of transaction to limit your tax burden. However, don’t forget to keep an eye on your overall returns, because you don’t want to suffer a net loss in the name of reducing your tax burden using a wash sale.