A Harsh Yet Hard-To-Enforce IRS Position On Wash Sales

The Internal Revenue Service is fascinated by the sound of metal striking metal. So we could conclude, at least, based on the Service’s penchant for rattling sabers.

One example of such misplaced attention cropped up in a ruling about wash sales. A wash sale occurs when a taxpayer sells a security, such as a stock or a bond, at a loss and repurchases the same security or a “substantially identical” one shortly before or after the sale.

The U.S. tax code specifies that wash sales are transactions that occur within a window of 30 days before or after the security’s sale. In these situations, taxpayers cannot claim the loss on the sale of the security.

However, deductions are only temporarily, not permanently, disallowed. The disallowed loss is added to the cost basis of the replacement security. Later, when the replacement security is sold, this change in basis creates a smaller gain or a bigger loss for the taxpayer. At that point, the “lost” deduction is effectively recovered. Wash sale rules are not meant to prevent taxpayers from taking deductions at all; they are designed to prevent investors from taking deductions on securities that they still hold.

The IRS wants custodians, such as Schwab, to track these sorts of transactions. But custodians are not able to track all of them. For one thing, people often own accounts at more than one custodian; one has no way of knowing what is going on at the other. For another thing, tax sheltered accounts like IRAs generally don’t track this activity at all. Since security sales in such accounts do not create tax deductions for their owners, wash sales within an IRA effectively don’t matter for tax purposes. Therefore, the responsibility for tracking largely falls on the taxpayers.

The IRS’ position, set out in a 2008 ruling, is that the wash sale rules still count if you sell a security out of a taxable account and repurchase in an IRA. Fair enough, as far as it goes. This would keep taxpayers from selling a security simply to claim a deduction and then buying it back, just as the rules do for taxable accounts.

But the Service goes further in the way it applies the rules in this scenario. Without citing any statute to support its position, and in direct contradiction to the basis-adjustment rule in Section 1091(d) (which the ruling says, without explanation, is inapplicable), the Service claims that not only must taxpayers have to disallow the loss arising through the IRA’s wash-sale purchase, they receive no basis in the IRA-owned security. This makes the loss of the deduction effectively permanent, instead of merely deferred.

An example: Will and Jack both buy 100 shares of stock in Company X at $10 per share. A year later, they both sell all the stock at $8 per share. A week later, Jack repurchases 100 shares of Company X’s stock at $6 a share through his taxable brokerage account. The same day, Will directs his IRA to buy 100 shares too, also at $6 per share.

Neither Jack nor Will can claim a deduction for the loss they incurred selling their stock. Jack, however, has an adjusted cost basis in his new shares of $800: $600 (the cost of acquisition) plus the disallowed $200 loss from the $8-per-share sale. Whenever Jack eventually sells the shares, the original loss will benefit him by either reducing his gain or increasing his loss. Will, on the other hand, cannot adjust the basis of the stock his IRA purchased, so his disallowed $200 loss vanishes, never to do him any good. Though Jack and Will have acted almost identically, Jack is better off.

It should be noted that the IRS has no practical way of monitoring such transactions other than voluntary reporting. The agency is thus setting up taxpayers like Will for a “lose-lose” situation. Such taxpayers’ reward for compliance in reporting their transactions is to come out worse than they would by reporting such a transaction for a taxable account, despite the fact that they have done nothing different according to the tax code.

The only way this decision will be overturned is an unlikely series of events in which: a taxpayer reports this sort of wash sale; the taxpayer later takes an IRA distribution with basis that reflects the wash sale; and the IRS then disallows this basis. At this point, the taxpayer could challenge the rule and take the issue before the tax court. But the odds of all three of these things happening in sequence are low.

In reality, this is simply another round of IRS saber rattling. The IRS hopes taxpayers will accede to its aggressive, unfair interpretation of the rules because the Service has only two other options, neither of which are appealing. It could decide that wash sale rules don’t apply to securities repurchased through a tax-sheltered account such as an IRA. Alternately, the Service could create a tax-planning opportunity that doesn’t currently exist. Usually, the capital loss you forego in a wash sale is lesser in value than the tax savings you create in the IRA, since IRA distributions are subject to ordinary income rates instead of capital gains rates. Getting basis in an IRA could create a more appealing prospect for taxpayers who would otherwise realize a loss on a security.

The IRS, however, has decided that such an opportunity is not what Congress wanted when writing the law, and so has interpreted the law broadly, in the worst possible way for the taxpayer. For now, taxpayers have little recourse other than to avoid triggering wash sale rules when purchasing securities with an IRA in order to avoid getting dinged by the harsh interpretation of the rules.

This kind of unfair interpretation discourages taxpayer compliance and ultimately hurts the IRS and the tax system. But such decisions are part of an IRS culture that too often sees maximizing revenue, rather than even-handed enforcement of the law, as the agency’s mission.

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