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What is the Wash Sale Rule

15 Sep 2023

Introduction

Everything goes by rules, and so does trading in the stock market. There are many rules in the stock market that an investor should obey. Otherwise, there are consequences. Moreover, rules are always made to prevent unwanted activities. One such rule of the stock market is known as the wash-sale rule.

You must have heard that a loss in an investment can be offset when filing taxes in most countries. The loss can be used to save you tax. The wash-sale rule was made to prevent a similar activity related to offsetting the loss. So, let's understand wash-sale and wash-sale rules in this blog.

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What is Wash-sale?

Wash sale is a way to create an artificial loss for oneself to use for fake tax deductions. It includes buying and selling of the same or substantially identical stocks. For example, a person sells some stocks or securities at a loss. That person can make a tax deduction based on the loss he has booked. But he then buys the same or substantially identical stock or security again to regain the same position.

The buying of the stock can be done before or after selling that stock. If you think about it, you'll find it can become an unlimited tax deduction glitch.

What is the Wash-sale rule?

To tackle this problem, the Internal Revenue Service came up with the wash-sale rule. This rule prevents this tax deduction glitch to ensure fair practices in the stock market and tax filing.

The rule says that a person can't buy the same or substantially identical stock or security that he has sold in the last 30 days or will sell in the next 30 days. It means there's a total of 61 days in which buying that same or substantially identical stock is prohibited.

The rule also states that the individual can't regain the position, even with a contract or an option. Moreover, the rule also restricts buying that stock by the spouse or a company of the individual.

What is a Substantially Identical Stock?

Mostly, the trader who does the wash-sale activity buys the exact same stock or security. But sometimes traders try to outsmart the law by buying a substantially identical stock. Substantially identical stock can be a bond or a preferred stock, which can be converted into the company's common stock. So, this way, the bond or preferred stock will have all the qualities of a common stock.

Final Words

Knowing about wash-sale is essential to avoid doing it even by mistake. However, there is no penalty for violating this rule. Only the fake tax deduction that was attempted will get reversed. So, if you also want to enter the stock market with your expertise, open your Demat Account with Motilal Oswal.

 

Related Articles: Principal Trading vs Agency Trading | Guide to Paper Trading | What is a Spot Rate | Secured Vs Unsecured Bonds

 

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