When you sell an investment for less than you paid for it, you might expect to use that loss to reduce your taxable income. But there’s an important IRS rule to keep in mind that can drastically change the impact and the timing of when you can receive that tax benefit: the wash sale rule.

The Wash Sale Rule Explained in Plain Language

After you sell a position and realize a tax loss, a wash sale occurs if you buy the exact same position, or one that the IRS deems substantially identical to the one you just sold, within the 30 days before or after the sale. If this happens, the IRS won’t let you take, or will “wash away”, the immediate tax deduction for that loss. Instead, the disallowed loss amount is added to the cost basis of the newly purchased holding, which effectively postpones the tax loss benefit until you sell the replacement security sometime in the future.

Overall, this IRS rule is designed to try and prevent investors from realizing a tax loss while maintaining essentially the same investment position, which at its core makes sense. The IRS traditionally takes the stance that if you’re going to get a tax benefit, there are rules you must follow.

Taxes and tax rules are normally very complex, but the wash sale rule becomes much easier to understand when you go through some simple examples.

Example of a Wash Sale

Let’s say you purchased 100 shares of hypothetical ABC Corp. at $50 per share, so your position is worth $5,000. But then the stock drops to $40, and your position is now worth $4,000. For one reason or another, you now decide to sell ABC Corp, which realizes a $1,000 loss that you can use to offset other capital gains or even some of your other income.

• Scenario A – Wash Sale: If you buy back ABC Corp. (or a substantially identical security) within 30 days, the $1,000 loss is disallowed (aka “washed away”) for now. Instead, that $1,000 loss you were trying to realize gets added to the cost basis of the new shares you purchased. If you repurchased them at $40 per share, your cost basis would be adjusted to $50 per share, which was the original cost basis you had. If the stock continues to move lower, and you eventually sell it again at $30/share, then you’d have a $2,000 loss because your adjusted basis is $50/share. In that way, the loss you tried to realize earlier isn’t gone; it was deferred.
• Scenario B – No Wash Sale: If you wait at least 31 days before buying back ABC Corp., the $1,000 loss can be recognized on your taxes in the current year. There are no changes needed since you’re outside the IRS wash sale time window. Simple as that.

How Direct Indexing and Tax-Loss Harvesting Fits In

Wash sales matter most when you’re actively looking to realize losses through tax-loss harvesting, which can be a major benefit of direct indexing strategies. Because direct indexing lets you own the individual stocks that make up an index (rather than just a mutual fund or ETF that tracks it), there are more opportunities to capture tax losses as each individual position you own moves up and down.

But that also means more potential for triggering wash sales if trades aren’t carefully managed. Every client’s trading history and portfolio are unique, so customization is key. That’s why strategies like direct indexing need to be executed with planning and precision, so you can avoid wash sales and stay tax-aware while remaining invested without drifting away from your intended portfolio allocation.

Want to dive deeper? Check out our article on Direct Indexing to learn how it works and why it’s becoming a powerful tool for tax-efficient investing.

Benefits of Understanding the Wash Sale Rule

• Consistent Tax Planning: Knowing how the rule works helps you keep the losses you realized and avoid surprises at tax time.
• Maintaining Overall Portfolio Strategy: Managing around wash sales creates opportunities to harvest losses thoughtfully while still keeping your portfolio aligned with your overall goals. For example, while we might sell ABC Corp., we can purchase shares of a company with the same risk profile, call it XYZ Corp., to keep similar market exposure without triggering a wash sale.
• Long-term planning: Even if you do incur a wash sale, understanding the rule means that your loss will not be eliminated but could only be deferred, and you may still capture its tax benefit in the future.

Costs and Trade-Offs of Wash Sales

• Missed Opportunities: Without a tax-aware plan of what to buy next, you might have to wait 31 days in cash before repurchasing a stock, and during that time the price may rebound, reducing your potential long-term gains.
• Inadequate Substitute Investments: Selling a stock and selecting replacement holdings without a plan may avoid wash sales but could drastically change the risk or return profile of your overall portfolio.
• Higher Audit Risk: Wash sales can lead to additional tax complexity, and misreporting wash sales (even unintentionally) can raise red flags with the IRS, causing an increased likelihood of an audit.

Key Takeaway

The wash sale rule is less about what you can’t do, and more about being strategic. Remember, wash sales won’t erase your tax losses, but they will delay the tax impact and possible benefits. In the end, it’s about understanding timing, trade-offs, and how each decision fits into your broader financial plan. The more complex your situation and portfolio, the more you’ll benefit from intentional portfolio decisions and a wealth advisor like Monument. We have the expertise and technology to help realize losses when appropriate, keep you invested for the long term, and avoid wash sales which delay the tax benefits you might be planning for.

But let’s be clear: The goal of investing is to make money; not to realize losses. But when markets sell off (and we all know they will at some point), it’s a great opportunity to look for potential tax benefits and tax-loss harvesting trades. At Monument, we believe taxes are one important factor in decision-making, but never the only one. Your allocation, goals, and time horizon should remain at the center. Our role is to help you see the options clearly, so you can act with intention when it matters most.