On June 15, 2009 you bought 100 shares of BP (BP plc ADR) at $50 per share. About two weeks ago, BP started its top kill operations. At $43 per share, BP was well below its 52-week high of $62.
With hope running high, you bought 100 additional shares for $4,300.
Yesterday, the BP ADR closed at $29.20. You have fallen into deep water, with no clear vision of the horizon.
Your 200 share position in BP consists of two tax lots. The first, year-old tax lot has an unrealized loss of about $2,100 (-$21 times 100 shares). For the second, more recent tax lot you have an unrealized loss of about $1,400.
Wash sale effect on cost basis
If you sell the first tax lot for a loss, you cannot deduct that loss from your net capital gains. The loss would be disallowed as a wash sale, because you bought substantially identical stock within 30 days prior to the sale.
This is the point where most discussions of the wash sale rule end. But the real damage has only just begun.
To account for the wash sale, you must add the disallowed loss to the cost basis of the purchase that triggered the wash sale. In this case, the second tax lot has its cost basis raised by $2,100 to $6,400. You also change the beginning of the holding period for the second tax lot to the purchase date of the stock sold.
The second tax lot now has an unrealized loss of $3,500, and its holding period began on June 15, 2009. Next week, on June 16, this loss will become long-term.
Avoid a wash sale that creates a long-term capital loss
Before your recent purchase two weeks ago, the first tax lot had an unrealized loss of $700. More significantly, the holding period for that lot was approaching one year. An earlier post pointed out the importance of recognizing short-term losses before they become long-term.
Adding to a stock position which has an unrealized capital loss starts a 30-day wash sale window. During that window, a sale of the stock for a loss will be disallowed. Particularly worrisome is when the window stretches the holding period of a tax lot beyond one year.