What is the Wash Sale Rule?

Key Highlights

• A wash sale occurs when you sell stocks online at a loss and then purchase the same stocks within 30 days.
• The best way to avoid this rule is to wait 30 days before investing in a similar investment or investing in an exchange-traded fund.
• An investor triggers a wash sale in order to reduce capital gains tax.
• The Internal Revenue Service (IRS), the primary tax authority in the United States, enacted the wash sale rule. In the Indian stock market, this rule does not exist.

Meaning of Wash Sale Rule

Wash sales occur when you sell stocks online at a loss and then purchase the same stocks within 30 days of the sale. To better understand the wash sale rule definition, let's look at a couple of examples.

Example 1 Let's say you buy a share of Infosys for Rs. 900. A year later, you see that the share price has dropped to Rs. 700. In order to avoid a loss (of 200 rupees), you sell the shares for 700 rupees. Following the sale transaction, you again decide to purchase Infosys for about Rs. 650 within a week. You would then be deemed to have made a wash sale in such a situation.

Example 2 Let's say you buy a futures contract for Infosys for around Rs. 900. In this example, we will assume that the lot size of the futures contract is just 1 share. Within a week, the futures contract value has dropped to around Rs. 800. You sell the futures contract and close your open position to book a loss (of Rs. 100). Two weeks after the sale transaction, you decide to purchase the same Infosys futures contract again for about Rs. 700. The 'sale' transaction that you made to close out your position would then be considered a wash sale.

What Causes Investors to Trigger a Wash Sale?

Stocks might have been sold for a loss by investors fearing that the share price would fall further. Some days later, investors might have heard of some uplifting news that could turn the stock bullish, so investors bought it again to profit from the price movement.

In some cases, investors intentionally trigger this rule. You might ask: Why would someone intentionally sell and then repurchase their stock? The answer is to reduce the amount of capital gains tax that an investor has to pay. It is also referred to as tax loss harvesting.

Wash Sale Rule in India

Profits that an investor makes through the buying and selling of stocks are referred to as capital gains and may be taxed depending on the length of the holding period. The more capital gains you make, the more tax you'll have to pay.

When an investor has already accumulated plenty of capital gains, they may intentionally trigger a loss to reduce the gains accumulated. As a result, they can reduce their capital gains and pay lower taxes. The stock is simply bought back after this loss is triggered.

This rule was enacted by the Internal Revenue Service (IRS) in the United States of America to prevent investors from using the rule to lower their taxes. In accordance with the rule, an investor cannot use any loss arising from a wash sale to reduce their capital gains. In the U.S., this rule effectively prohibits the harvesting of tax losses. So, what about India? Fortunately, the wash sale rule in India doesn't exist and only applies to the United States.

Conclusion

A wash sale rule is an Internal Revenue Service (IRS) regulation that applies exclusively to the United States. According to the rule, a wash sale loss cannot be used to offset capital gains and reduce taxes. However, India does not have a wash sale rule, so Indian investors may use a wash sale to harvest their tax losses without fear of negative consequences.