A blog about stock portfolio management

Tax loss harvesting and the wash sale rule

July 26, 2010

In the preceding post we noted the risk of an unrealized capital loss becoming long-term due to a wash sale. Tax loss harvesting also creates a situation constrained by the wash sale rule.

Tax loss harvesting

As in the preceding post, suppose you bought 100 shares of BP (BP plc ADR) at $50 per share on June 15, 2009. Two months ago on May 26, 2010, BP stock was at $43 per share. You had an unrealized short-term capital loss of about $700.

Rather than buying more BP stock, you sold 100 shares for $4,300. This action is also known as harvesting a tax loss. This loss would offset any short-term capital gains in your taxable portfolios.

Two weeks later on June 9, BP closed at $29.20. To rebalance your asset allocation, you were anxious to restore your holding in BP. On June 10 you bought 100 shares for $3,100. This purchase triggered a wash sale and negated the whole purpose of harvesting the tax loss.

Wash sale effect on cost basis

The short-term loss that you recognized on May 26 would be disallowed as a wash sale, because you bought substantially identical stock within 30 days after the sale.

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 tax lot for the June 10 purchase had its cost basis raised by $700 to $3,800. You also change the beginning of the holding period of the tax lot to the purchase date of the stock sold.

The tax lot now has an unrealized loss of $700, and its holding period began on June 15, 2009. On June 16, this loss became long-term.

Tax loss harvesting starts a 30-day wash sale window

Recognizing a capital loss in a taxable portfolio sets up the potential for a wash sale during the next 30 days. To avoid a wash sale that would disallow the prior capital loss, you have two choices.

You can wait 31 days after the loss before buying replacement stock. While simple, this choice has a major drawback. During the period when the portfolio lacks the holding that had been sold, your asset allocation may differ from your chosen allocation.

Should maintaining a balanced asset allocation be of primary importance to your investment strategy, you can immediately replace the BP stock sold with similar stock in the same industry. As a substitute for BP, you might purchase another international oil company such as XOM (Exxon Mobil), RDS.A (Royal Dutch Shell) or CVX (Chevron Corp).

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