What is a Wash Sale?

Some investors use techniques like Wash Sales in an attempt to manipulate the stock market. Such manipulation is illegal and there are substantial financial consequences of the practice. The government restriction that controls these sales applies to mutual funds and other stock transfers, so it is important to understand what you can and cannot do in building your investment portfolio.

The term applies to the sale of a security at a loss followed within thirty days by the repurchase of a “substantially identical” asset. This is done to capitalize on the loss while still maintaining the stock or fund in the portfolio and results in a zero net gain for the investor. It also can be done in an attempt to create a false appearance of market activity in the asset and so raise the value of a company.

Why Keep a Failing Stock?

Stocks are often volatile and their values are affected by many things. Droughts may affect fruit prices and lagging demand could lower petroleum stock prices. Some stock prices have plummeted because of scandals in management. The point is that these fluctuations are normal and don’t necessarily mean the stock won’t regain its value. If an investor wants to keep a certain type of asset, for instance solar power, he may attempt to use the wash technique to make up for a temporary lag in stock prices in the company in which he holds stock.

What is the Rule Affecting These Sales?

The law hinges on the term “substantially identical” according to Investopedia. These are stocks that are so similar that the government does not see any difference between them. An investor could, for instance, hold stocks in a company that is later restructured and that offers the same asset in a slightly different form. Investors might also seek to “swap” preferred stocks for common stocks where there is no regulation or great difference in things like voting rights. An investor may not sell a financial asset at a loss and buy a “substantially identical” asset within thirty days before or after the sale. The consequence of doing so is that the government discounts the loss. In other words, there is no tax benefit to the investor. Besides this, the trade waiting period is added to that of the original stock and the loss is added to the new stock cost-base.

Examples of The Wash Technique.

An investor could own one hundred shares of “Outstanding Outerwear” worth ten dollars a share, or $1,000. Then, for some reason, the stock value falls to seven dollars and the investor sells, netting a loss of $300. A week later the stock rebounds to nine dollars a share and the investor buys one hundred shares. The law prohibits him from claiming that $300 loss on a stock that he still owns. Another tack investors sometimes use is to buy a stock from one investment house and then sell it through another broker. This is still a wash transaction because the rule applies to the investor and not the stock or the brokerage. According to Schwab.com, if the investor in the above example really wanted to keep a clothing asset in his portfolio while benefiting from the loss tax break, he might research the market and buy a stock that is as good or better than the original at the same time he sells the devalued stock.

There are many ways to manipulate the stock market. Savvy traders will research their transactions before engaging in a sale or purchase that may backfire financially. Brokers are required to report a Wash Sale and the consequences to the investor could prove costly.