What is Wash Sale?

An investor must be knowledgeable about investing in equities. This includes trading and the stock exchange. It is also important to understand the potential ramifications of this. As an investor, there are two concepts you need to be aware of: the wash sale and wash sale rule. These unique concepts are explained in detail here.

What's a wash sale?

Let's start by understanding what a wash sales is before we move on to the wash-off rule.

A wash sale is when an investor sells stock or other security at a loss, and then purchases the same stock or security again within the period of 30 days prior or after the date for the sale.

Wash sale examples

Let's look at some examples of wash sales to help us better understand the concept.

Example 1

Let's say you purchase a share in Infosys at Rs. You pay Rs. 900. One year later, the share price had dropped to Rs. 700 You decide to book a loss of Rs. You decide to book a loss (of Rs. 700 You decide to purchase another Infosys share for Rs. 650 In this situation, the sale transaction you made would be deemed a wash sale.

Example 2

Let's say you decide to buy a futures contract from Infosys at Rs. 900 Let's assume, for the sake of this example that the lot size for the futures contract is 1 share. You find out that the futures contract's value has fallen to Rs. a week later. 800 You decide to take a loss of Rs. 100 by closing your open position and selling the futures contract. You decide to purchase the same futures contract from Infosys again for Rs. 700 This would mean that the "sale" transaction you made to close your position is considered a "wash sale".

What's the logic behind a wash-sale?

Now that you have an understanding of the concept using these wash sale examples, let us delve deeper to see why an investor would purchase the same security once again after a loss.

To protect his investment capital, an investor may sell a losing stock or security. After a few trading sessions, an investor might find that the current stock price seems attractive enough to make a purchase. In this scenario, the wash sales transaction is inadvertently triggered.

An investor may also initiate a wash sale to lower capital gains taxes that must be paid to government. Tax loss harvesting is another name for this method of deliberately triggering a wash sell.

Triggering an wash sales to tax loss harvesting

A profit earned from the sale or purchase of stock is either a long-term capital loss or a short term capital gain, depending on how long the stock was held before being sold. The Income Tax Act of 1961 allows you to offset your short-term and long-term capital gains by capital losses or long-term capital gains, and pay no tax.

Investors might be able to trigger a wash sell, in which they deliberately sell their loss-making stock to offset the capital gains and capital losses. This simple act can help reduce their tax liability.

The wash-sale rule

The wash sale rule, technically speaking, is an Internal Revenue Service regulation that only applies to the United States of America. The wash sale rule states that an investor cannot use any loss from a wash sale to offset his capital gains or reduce his tax liability.

Indian tax authorities do not have a wash sale rule. Therefore, Indian investors are allowed to use wash sales for tax loss harvesting purposes.

Here is an example of how the wash sale can be used in India.

Let's say you own a share in Ashok Leyland. The share price dropped from Rs. 100 (the purchase price) has fallen to Rs. 60 You have an unrealized loss of approximately Rs. 40

You also have a share in TCS. TCS stock shares have risen in value from Rs. The price you paid to buy the TCS stock has risen from Rs.2,000 to Rs. 2,100 At the moment, you have an unrealized profit of approximately Rs. 100. This share is to be sold for Rs. 100 profit

The profit of Rs. 100 is the capital gain for which you must pay tax. To reduce your tax burden, you can also sell the Ashok Leyland shares you owned for Rs. 60 This transaction has resulted in a loss of Rs. This transaction cost 40

However, you aren't really able to give up your Ashok Leyland share. So, you instantly buy Ashok Leyland's share at Rs. 60 This is what ultimately leads to a wash sale transaction.

The loss of Rs. can be offset by setting up the loss at Rs. 40 to Rs. Your net capital gain would only be Rs. 60 on which you would have to pay tax. This will reduce your tax liability.

Conclusion

You can use this type of transaction to reduce your tax burden, as the wash sale rule in India is not applicable. You don't want to lose any money by using wash sales to reduce your tax burden.