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. Less than a month 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.

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.