Knowing how to buy and sell stocks online may not always be enough to make you a successful trader. You also need to have knowledge on various concepts like the wash sale rule. Wondering what it is? Continue reading to know all about this unique concept.
A wash sale is when you sell stocks online for a loss and then purchase the same stocks within 30 days from the date of sale. Confused? Here’s an example to help clear things out.
Say that you’re interested in the stock of Tata Motors, whose current trading price is Rs. 330. You purchase around 100 shares of Tata Motors at Rs. 330 per share. After a month or so, the share price of the stock declines to Rs. 300 per share. Now, you decide to book a loss and sell all of your 100 shares for Rs. 300 per share. As a result, you end up with a loss of Rs. 3,000.
However, after around 10 days of selling the shares for a loss, you decide to buy the shares of Tata Motors once again. Now, when you purchase the stock of Tata Motors for the second time, the transaction that you made where you sell the 100 shares of Tata Motors for a loss of Rs. 3,000 would automatically be termed as a wash sale.
In the above example, what do you think might possibly be the reason behind buying the stock of Tata Motors for the second time despite having sold it for a loss the first time?
You might have sold the stock for a loss fearing that the share price would fall down further. And 10 days later, you might have heard of some uplifting news with the potential to turn the stock bullish, and so you purchased it once again to cash in on the price movement.
Now, in the above case, the wash sale is triggered inadvertently. There are certain cases where investors intentionally trigger a wash sale as well. Why would someone intentionally sell their stock for a loss and buy it back again, you ask? To reduce the amount of capital gains tax that the investor has to pay to the authorities. This is also known as tax loss harvesting.
The profits that an investor makes through the buying and selling of stocks is termed as capital gains and are liable to be taxed according to the period of holding. The more the capital gains, the more the tax you’re required to pay.
Now, if an investor has already accumulated plenty of capital gains, they will sometimes trigger a loss intentionally, which allows them to set off the loss against the accumulated capital gains. This way, they can reduce the capital gains and therefore pay lower taxes. And once they’ve triggered this loss, they simply buy the stock back again.
In a bid to prevent investors from utilizing wash sales to lower their taxes, the wash sale rule was enacted by the Internal Revenue Service (IRS) in the United States of America. According to the wash sale rule, any loss arising out of a wash sale cannot be used to lower the capital gains generated by an investor. This rule effectively puts a stop to tax loss harvesting in the U.S.A.
What about India then? Fortunately, the wash sale rule doesn’t exist in India and is specific only to the United States of America. What this means is that you can use tax loss harvesting to reduce your overall tax liability freely. Now that your question of ‘what is a wash sale in stocks?’ is answered, visit the website of Motilal Oswal right now to open an online demat account for free.
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