Can you explain the wash sale rule in detail?

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AcadiFi · Accepted Answer

The wash sale rule under IRC Section 1091 disallows a loss deduction if the taxpayer purchases substantially identical securities within 30 days before or after selling at a loss...

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Substantially identical definition: the IRS has not issued bright-line guidance but the general interpretation is — same security issued by same entity is clearly identical (same CUSIP). Different share classes of the same company (voting versus non-voting) are typically identical. Different ETFs tracking the same underlying index (e.g., two S&P 500 funds from different providers) are a gray area — most practitioners treat them as substantially identical, some do not. Different ETFs tracking different indices (even similar ones like S&P 500 vs Russell 1000) are generally not substantially identical. Options and the underlying stock are typically treated as substantially identical.

Worked scenarios:
Valid harvest: sell broad US large-cap ETF at loss, immediately buy a total-market ETF from different provider — not substantially identical.
Wash sale triggered: sell 100 shares at loss, buy back 100 shares 15 days later — loss disallowed, added to basis of replacement.
Wash sale triggered across accounts: sell at loss in taxable brokerage, buy in IRA within 30 days — loss disallowed, and basis adjustment does NOT transfer to IRA (permanent loss).
Partial wash sale: sell 1,000 shares at loss, buy back 400 within window — 40% of loss disallowed, 60% preserved.

```mermaid
flowchart TD
  A[Sell at Loss] --> B{Repurchase Window}
  B -->|Same Security| C[Disallowed]
  B -->|Similar ETF| D[Gray Area]
  B -->|Different Index| E[Allowed]
  C --> F[Added to Basis]
```

IRA trap: the most painful wash sale scenario occurs when an investor sells at a loss in a taxable account while their IRA buys the same security (perhaps from an auto-invest program). The loss is permanently disallowed and the basis adjustment cannot be applied to the IRA holding. Dino and Greta Sorensen lost $18,000 in disallowed losses due to automatic IRA purchases during harvesting attempts — until they coordinated account timing.

Practical coordination: review all household accounts including spouse's accounts, IRAs, 401(k)s, and taxable brokerage before selling at loss. Turn off automatic dividend reinvestment during harvesting windows. For CFA Level III, recognize that wash sale violations not only eliminate current-year benefit but can create permanent tax drag when basis adjustment cannot be applied to tax-sheltered purchases.

Can you explain the wash sale rule in detail?

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