Last week I was at a wonderful local sushi restaurant with my friend, Deane, a successful tech executive. Over dinner, he told me that he unexpectedly owed more taxes. The so-called “wash sale” rule caused the surprise. He asked me to explain this financial concept.
Wash Sale!? Finance has the strangest jargon. Where did this name come from? I haven’t the slightest idea.
Wash Sale Definition
The Internal Revenue Service (IRS) says that a wash sale occurs if you sell company shares for a loss and buy more company shares within 30 calendar days before or after the loss transaction. Because the window is 30 days before or after the sale, the window is really 61 days. Be careful!
The IRS does this because when you sell stocks at a loss, you might get a tax benefit. A capital loss can be used to reduce capital gains or reduce your regular income up to $3,000 per year.
For example, if you purchase stock XYZ for $100 and then sell it for $80, you have a $20 capital loss. You can use this $20 loss for your tax benefit as long as you don’t violate the wash sale rule.
RSU Wash Sales
Here’s where it gets technical, so bear with me. At this point during our lunch, Deane ordered a coffee.
When your RSUs vest, you receive the shares of company stock. The value of the shares received is taxed as ordinary income.
From the IRS’ perspective, the vest date and acquisition date are the same for wash sales. If you sell your RSUs at a loss within 30 days of shares vesting (before and after vesting date), there could be RSU wash sale issues.
When you have monthly vesting, this is a very delicate situation.
Note that wash sale rules only apply to losses, not gains. Before you sell your RSUs at a loss, check the vest date for all of your RSU grants to make sure no RSUs are vesting 30 days before or 30 days after.
The main consequence is that the loss from a sale of securities that prompts the wash sale rule will be disallowed. You cannot claim the loss on your tax return to offset gains from other sales or income.
On the contrary, the disallowed loss is added to the cost basis of the new securities that were purchased within the wash sale window.
Here’s an example of how it works.
You sell shares of stock (that you already own) at a $10,000 loss when new RSU shares vest within the 61-day wash sale period. The $10,000 loss would be disallowed and added to the cost basis of the newly vested shares.
If the newly vested RSUs have a vesting value (cost basis) of $50,000, your cost basis for tax purposes will be $60,000 ($50,000 + $10,000).
Here’s a more detailed timeline example that shows how a wash sale occurs with RSUs and stock options.
- On January 1st of Year 1, you receive an RSU grant as part of your compensation package. The RSUs vest over a four year period, with 25% of the shares vesting on January 1st of each year.
- On January 1st of Year 2, your first chunk of RSUs vest and you receive the shares of company stock. The value of the shares is taxed as ordinary income.
- On February 1st of Year 2, you sell some of the shares from the first chunk of RSUs at a loss.
- On February 15th of Year 2, you exercise options in your company. This is a purchase of identical shares, and you have a wash sale.
- The wash sale prohibits the loss from the sale of shares in Step 3. This loss cannot be used to offset gains from other sales or income.
- The disallowed loss is added to the cost basis of the new shares purchased in Step 4. This impacts the tax liability of these shares when they are sold in the future.
It’s important to be aware of your vesting schedule and sales and purchases of your company stock to avoid the wash sale rule.
Strategy For You
This is a very dry, but important concept.
To make it easier, keep track of all vests, purchases, and sales of securities throughout the year – both gains and losses. If applicable, calculate the disallowed loss for each wash sale.
Then adjust the cost basis of the new securities vested or purchased within the 61-day window to include the disallowed losses. This is so you don’t pay taxes twice on the same loss.
The rules and regulations around wash sales and capital gains are complex so it’s a great idea to develop a strategy with a knowledgeable financial planner and a CPA.