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| Looking to Duck the Wash Sale Rule? Don’t Use Your IRA |
02-17-2009 |
The wash sale rule, that Gordian knot of trader taxation, just took a few more strange twists and kinks, thanks to a recent, somewhat baffling ruling by the Internal Revenue Service.
At issue was whether a taxpayer can avoid the wash sale rule by purchasing replacement stock inside their IRA (as opposed to buying it personally) within the required 30-day period before or after the sale of a security.
To this, the IRS now says no dice – if you buy replacement stock inside your IRA instead of purchasing it personally, the taxman says you can’t recognize a loss on the sale. Never mind deferring that loss by increasing the stock basis in his IRA as provided for under the wash sale rule; the IRS says the IRA play eliminates the loss altogether for tax purposes.
Hanging Out with Wash Sales
A wash sale, of course, results when a taxpayer sells a stock or other security and purchases replacement stock that is “substantially identical” within the 30 days before or after the sale. The trader or investor thereby ends up in the same position from which they started – in other words, their trades resulted in a proverbial “wash,” hence the name.
Under the wash sale rule, when a wash sale results in a loss, the investor is prohibited from recognizing a capital loss, something the IRS loathes. Instead, they are allowed to defer the loss by adding it to the basis of the replacement stock, which will either increase any future loss or reduce future gain by that amount.
In the case under review, a taxpayer sold 100 shares of stock at a loss and repurchased the same stock the next day through his IRA or Roth IRA. The IRS disallowed the taxpayer’s right to declare a loss on the sale and, citing a 1933 tax appeals case, further prohibited the claimant from adding the loss to the basis in the IRA. The result: no loss claim whatsoever, not even deferred.
Wash sale rules are so convoluted and their record keeping so laborious that most traders elect the mark-to-market accounting method to avoid them. Mark-to-market traders are exempt from the wash sale rule – because holdings are tallied at year’s end (in other words, marked to market), there is no need to account for gains or losses that might occur within the 30-day wash sale restrictions.
But beware: mark-to-market is not the best move for everyone. For instance, if you are carrying forward a substantial capital loss, under MTM, your gains moving forward would be treated as ordinary income. Because capital losses can only be offset by capital gains, you would only be able to apply $3,000 per year to offset your capital loss.
Similarly, traders who deal mainly with 1256 contracts often choose to forego MTM “loss insurance” in order to retain their favorable 60% long-term capital gain tax rate on commodities gains. Traders Accounting, your trader tax experts, can advise you on the best accounting method for your individual situation.
More Questions Than Answers
Trading within your IRA is perfectly acceptable; it received the green light with passage of the Economic Growth and Tax Relief Reconciliation Act of 2001. In addition to margin trading and short sales, you also can invest your IRA in a wide variety of non-traditional investments, including real estate, deeds of trust, certain business entities and coins.
While the latest IRS resolution certainly seems to close the door on using individual retirement accounts to avoid application of the wash sale rule, it raises questions about which direction the taxman is heading with regard to wash sales in general.
For instance, why would the IRS completely disallow a loss within the context of a statute specifically designed to defer losses? And why would it bring in as supporting argument a 75-year-old appeals court ruling that seems quaint if not irrelevant today?
We may never know. One thing remains clear however: the complex world of trader taxation is a foggy, ill-defined and ever-changing landscape with numerous pitfalls to trip up the ill prepared or inexperienced.
Fortunately, Traders Accounting knows the territory well. As traders and accountants, we’re the nation’s experts on trader tax issues, from entity formation to tax preparation and long-term planning.
Tax laws and their application continue to change, but Traders Accounting remains the steady source of proven trader tax advice. Call today to find out how we can lower your taxes immediately.
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