How to Avoid Phantom Income From Wash Sale Loss Adjustments

Day and swing traders inevitably trigger many wash sale loss adjustments (WS) amounting to tens or hundreds of thousands of dollars. Take a loss on a security, repurchase it within 30 days (after or before), and that creates a WS loss, states Robert Green of GreenTraderTax.com.

A WS reduces the cost basis on the position sold and adds the WS loss to the replacement position’s cost basis. That defers the WS loss, creating phantom taxable income and capital gains taxes.

It’s okay to incur WS losses during the year but try to avoid delaying the WS losses to the following year. Deferring a loss from November to December is acceptable; however, postponing a loss from December 2022 to January 2023 is not.

Learn how to “break the WS chain” at year-end. For example, sell your entire position in security A by December 20, 2022, and don’t repurchase security A for 30 days to around January 21, 2023. That doesn’t provide a WS bridge from the tax year 2022 to 2023. Deduct the whole year of WS losses in 2022, with no deferral of WS losses to 2023.

When you get your broker-issued Form 1099-B showing massive WS loss adjustments, don’t panic. What’s critical is the number of WS open at year-end for which you repurchased positions within 30 days in January 2023. For example, suppose the WS loss adjustments column on the 1099-B is $500,000. If you avoided all WS at year-end by refraining from repurchases in January, the Cost Basis column should be $500,000 greater than your actual purchase price.

On the 1099-B, calculate taxable income by Proceeds, minus Cost Basis, plus WS loss adjustments. There’s a quirky WS rule between taxable and IRA accounts. The WS loss becomes permanent if you take a loss in a taxable account and repurchase the security position within 30 days in an IRA.

The IRS does not allow you to add the WS loss adjustment to the IRA cost basis. Yet, the IRS requires a reduction of the cost basis in the taxable account. Avoid this problem with a “do not invest list” in the IRAs vs. what you trade and invest in taxable accounts. This WS rule applies to taxable vs. IRA accounts; an IRA account on its own is not subject to WS losses.

A trader eligible for trader tax status with a Section 475 MTM election is exempt from WS on trades. 

Learn More from Robert Green at GreenTraderTax.com.