Why Are Some Stock Losses Disallowed?

There is an old adage that every cloud has a silver lining. When it comes to stock losses, that’s absolutely true. Big stock gains come with big tax bills. Big stock losses come with tax breaks… Most of the time.

The rules around deductions for stock losses are complicated, and there are situations in which deductions for stock losses are disallowed.

Tax advisors are the best resource for information on individual circumstances. However, becoming familiar with basic guidelines makes it easier to develop a comprehensive tax minimization strategy – and that’s a must when investments aren’t performing.

Why Are Stock Losses Tax Deductible?

Before looking at whether and when to claim losses, many investors want to know the why. After all, isn’t the risk of realizing a loss something stockholders knowingly take on when they buy stock? Why would bad investments be subsidized with tax breaks?

Believe it or not, a majority of the lawmakers who develop the tax code try to keep things fair. The goal is to base tax rates on taxpayers’ ability to pay. People with more income are subject to a higher tax rate, while those who are struggling financially keep more of their income.

When it comes to investment income, tax regulations require investors to pay a portion of their profits to the government. It’s only fair to treat losses in a similar manner by allowing deductions.

Is It Worth It To Claim Stock Losses?

Everyone wants a portfolio full of winners that increase in value. Unfortunately, that’s not how the stock market works.

Yes, it’s possible to pick stocks that deliver reliable returns over time, but in most cases, those stocks belong to established companies well beyond the stage of rapid growth.

That means the returns are there, but they are not especially impressive. And even consistent performers can have down years – particularly when the economy as a whole is facing challenges.

Growth stocks offer a good opportunity to push total returns up, but they carry more risk. They don’t always have the resources necessary to navigate volatile economic conditions, and they are far more likely than established peers to fail without warning if they find themselves unable to compete effectively in their chosen market.

Most investors build portfolios that balance risk and reward, so they can benefit from the higher returns of growth companies as well as the safety of established stocks. When all goes well, investors are rewarded with strong returns. When that happens, it goes without saying that the IRS wants its cut.

Tax rates on stock profits can be higher than standard income tax rates. At the moment, short-term capital gains are taxed between 10 percent and 37 percent. Long-term capital gains taxes are lower – between 0 percent and 20 percent – but eliminating taxes altogether is even better.

Can You Write Off 100% Of Stock Losses?

Stock losses can be used to offset stock gains for tax purposes, and that may translate into significant savings. Better still, if there are no stock gains to offset, stock losses can still reduce tax bills.

At the moment, up to $3,000 in losses can be deducted against ordinary income. If losses exceed the $3,000 maximum, remaining losses can be deducted from ordinary income in future years.

In theory, that means 100 percent of stock losses can be written off, though it might take multiple years to realize the full benefits. However, in practice, that’s not always the case. There are situations in which stock losses are disallowed – and that can be a big shock if the sell order has already been executed.

Why Are Some Stock Losses Disallowed?

Stock loss deductions are intended to create balance so that investors who are paying taxes on gains get credit when those gains are offset by losses. The deductions aren’t intended to provide a loophole so that investors can avoid capital gains taxes altogether.

One of the most common strategies for avoiding taxes is to take advantage of stock loss deductions by selling shares at a loss, using the losses to offset capital gains, then repurchasing the same or very similar stocks within a few days or weeks.

This plan appears foolproof – especially if the losing stock is expected to go up at some point. Investors offset their gains, save on taxes, and then get their shares back to round out their portfolios.

Unfortunately, it doesn’t work. The IRS is onto this particular strategy, known as a wash sale, and it is explicitly prohibited.

Why Is My Wash Sale Loss Disallowed?

Taxpayers come up with all sorts of ways to keep their tax bills low. In some cases, they are making the most of savings opportunities written into the tax code. In other cases, they are getting creative in ways that cross the line. While there isn’t anything wrong with selling assets at a loss and reinvesting the proceeds, losses related to a wash sale scenario cannot be deducted for tax purposes.

For example, consider a situation in which an investor buys 100 shares of ABC company. The shares are purchased for a total of $20,000 ($200 per share). A month later, the shares are valued at $17,000.

The investor wants to save on taxes, so all 100 shares are sold for a total loss of $3,000.

Two weeks later, the investor buys the same 100 shares again. By the end of the year, the shares are still valued at $17,000.

Can that $3,000 loss be used to offset capital gains? According to the wash sale rule, it cannot. The shares were repurchased within 30 days of the sale.

When the exact stock is not involved, defining what constitutes a wash sale can be difficult. The guidelines essentially state that if proceeds from the sale of assets that create a loss are used to buy assets that are the same or “substantially identical” within 30 days, the losses cannot be used to offset other taxable income.

In other words, wash sale losses are disallowed. The trouble is that the exact definition of “substantially identical” isn’t provided. Consulting with a tax advisor is the best way to stay out of hot water with the IRS.

How Do You Fix A Wash Sale Loss Disallowed?

Fixing a wash sale that is disallowed is far more difficult than avoiding the problem in the first place. If the goal is to ensure losses will be eligible for offsetting gains on other income, reinvest the proceeds of stock sales into a related – but not identical – stock or fund until the 30-day period expires. When the sale includes assets like mutual funds or exchange-traded funds, reinvest in a fund with a different asset mix or one that tracks an entirely different index for the 30-day period.

Note that the wash sale rule applies to the taxpayer, not the account, so selling in one account and buying in another does not avoid the wash sale rule. Along the same lines, married couples are considered a single unit for tax purposes, so if one spouse sells an asset at a loss and the other spouse repurchases the same asset before the 30-day period has expired, the wash sale rule applies.

It’s also important to keep in mind that the wash sale rule applies even when the 30-day period crosses tax years – for example, the sale occurs on December 21st, and shares are repurchased on January 2nd. It also applies in situations where the asset is purchased first, then sold within 30 days. The wash sale rule doesn’t consider whether the sale occurred first – only that the two transactions occurred within 30 days of each other.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.