What is a wash sale and how does my broker report them?

When trading and planning for taxes, investors need to be aware of a type of transaction called a wash sale. The wash sale rule is in place to prevent investors from trying to game the tax system by selling securities at a loss to reap the tax benefit, and then buying them back in more favorable conditions to also benefit from a potential gain.

But that said, the rule is tricky enough that many investors can unknowingly fall under its purview without having had any intent to gain favorable tax treatment. Let's look at what a wash sale is, how brokers such as E*TRADE from Morgan Stanley track and report them to you, and what potential pitfalls you should keep in mind.

The IRS wash sale rules may apply when you sell or trade a stock or other security at a loss. It will be classified as a wash sale if you do one of the following things within a 61-day period beginning 30 days before the sale and ending 30 days after it:

• Buy substantially identical stock or securities
• Acquire substantially identical stock or securities in a fully taxable trade
• Acquire a contract or option to buy substantially identical stock or securities

The wash sale rules also apply to a loss realized on a short sale if you enter into another substantially identical short sale 30 days before or after you closed the position.

When you have a wash sale, the loss is "disallowed", meaning you can't use the loss to reduce the amount of capital gains that you report on Schedule D of your tax return. The rules exist to prevent investors from realizing a loss just to reduce the taxes they owe, then immediately reestablishing the position they sold. (Note that if you are a trader using the mark-to-market accounting method, wash sale rules and reporting don't apply to you.)

The IRS requires brokers such as E*TRADE to track and report wash sales that involve stocks, bonds, and most other common securities when “covered” by the IRS’s cost basis reporting rules (called "covered securities") if they occur within a single account. Brokers provide that information to you on your 1099-B forms to help you prepare your taxes.

So far, so good, but there's a key fact you need to know: the IRS expects you to correctly account for your wash sales across all your investments, even if the trades involved non-covered securities or occurred in different accounts or through different brokers. If you had such transactions, they may not be shown as wash sales in the 1099-B forms you receive from any individual broker, including E*TRADE. So—you may need to independently determine if such transactions are covered by the wash sale rules.

When your broker determines that a wash sale occurred in your account, they are required to:

• Calculate the loss amount of the trade and carry it forward into the cost basis of the replacement securities that you bought.
• Create a 1099-B for the sale, which shows the details of the trade, including the disallowed loss, the cost basis of the tax lots sold, whether the position is short-term or long-term, and more. Note that in a wash sale situation, determining whether a position is short-term or long-term is based on the number of days the linked positions were actually held. If there was a gap between the sale and when you reestablished the position, the gap days are not counted towards your holding period.

E*TRADE from Morgan Stanley does not offer tax advice and we strongly recommend that you talk with your tax advisor about wash sale rules and reporting. With that in mind, here are some key things to watch for in order to help you correctly account for wash sales when you're preparing your taxes:

• As we mentioned above, you must take into account all your transactions in every account with all your brokers, as well as both covered and non-covered securities.
• If you have multiple accounts or brokers, you may have to synchronize all the 1099-B information that you receive, along with other transaction records, in order to properly identify wash sales that occurred across accounts. In that case, the wash sale information in your 1099-B forms may not match the Schedule D that you ultimately file with your tax return.
• Dividend reinvestment and employee stock plan acquisitions may also create a wash sale, which may be reported on your 1099-B. This can happen even if the amount of shares you acquired is not the same as the amount of shares you sold.
• Brokers are required to issue updated 1099-B forms to replace previously issued 1099-B forms when pertinent information changes. This requirement holds for up to three years after the initial 1099-B was issued and regardless of the dollar amount involved. If you get an updated 1099-B, you may have to recalculate and refile a previous year's Schedule D and Form 1040. Some common reasons why updated 1099-B forms may be issued include:
  
  
  • The broker receives updates or changes to information about transferred securities
  • Previously reported trades are cancelled or corrected
  • There's a restatement of tax lots applied to a sale
  • Corporate action (e.g., dividend) data is updated

In short, there can be a lot of challenges involved in correctly accounting for your wash sales. You can do yourself a big favor by keeping a close eye on your accounts and especially on any transfers of securities between brokers. Double-check that all the transfer information is correct and notify your broker right away if you see any discrepancies or mistakes of any kind in your accounts.