Wash sale rule impact on different scenarios between different types of accounts

Question

When wash sale rule kicks in, then the capital loss is simply postponed by increasing cost basis to the later transaction where you again purchased similar replacement stock either 30 days before closing the first transaction or 30 days after closing the first transaction. Also, the wash sale rule can be triggered when you trade the same stock in pre-tax IRA and typical post-tax brokerage account.

So here are all the possible scenarios, where assumption is that replacement stock was bought within 30 days (Initial purchase -> Replacement purchase). How, each of these 16 cases would be taxed?

IRA->IRA

1. Sold stock in IRA at loss, then repurchased stock in IRA and sold with loss
2. Sold stock in IRA at loss, then repurchased stock in IRA and sold with gain
3. Sold stock in IRA at gain, then repurchased stock in IRA and sold with loss
4. Sold stock in IRA at gain, then repurchased stock in IRA and sold with gain

IRA->Brokerage

5. Sold stock in IRA at loss, then repurchased stock in Brokerage and sold with loss
6. Sold stock in IRA at loss, then repurchased stock in Brokerage and sold with gain
7. Sold stock in IRA at gain, then repurchased stock in Brokerage and sold with loss
8. Sold stock in IRA at gain, then repurchased stock in Brokerage and sold with gain

Brokerage->IRA

9. Sold stock in Brokerage at loss, then repurchased stock in IRA and sold with loss
10. Sold stock in Brokerage at loss, then repurchased stock in IRA and sold with gain
11. Sold stock in Brokerage at gain, then repurchased stock in IRA and sold with loss
12. Sold stock in Brokerage at gain, then repurchased stock in IRA and sold with gain

Brokerage->Brokerage

13. Sold stock in Brokerage at loss, then repurchased stock in Brokerage and sold with loss
14. Sold stock in Brokerage at loss, then repurchased stock in Brokerage and sold with gain
15. Sold stock in Brokerage at gain, then repurchased stock in Brokerage and sold with loss
16. Sold stock in Brokerage at gain, then repurchased stock in Brokerage and sold with gain

Here is my understanding which may be wrong:

• in cases 1,2,3,4 wash sale rule should not matter at all because both transactions were made in pre-tax IRA account anyway. Right?
• in cases 4,8,12,16 wash sale rule should not matter because both transactions were with with gain. Right?

However, I am confused about:

• cases 5,6 because can I really use loss from my IRA account to increase cost basis for transactions made in my Brokerage account? If so, then this sounds like a nice tax loophole where pre-tax loss could be used to offset post-tax gain.
• cases 9,10, because do I really have to pointlessly increase cost basis for IRA transaction and give up my rights to keep capital loss in my brokerage accou t? If so, then this sounds like a "tax trap" that should be avoided at all costs.
• in cases 3,7,11,15 wash sale rule does not matter, because first transaction was with gain and the second transaction will remain as-is without requiring cost basis recalculation. Right?
• in cases 13,14 any capital loss really would not be lost, but simply postponed to the second transaction. Typically this should not matter unless you were planning to claim loss in particular Tax year when first transaction was closed, but could not because capital loss was moved to next Tax year.

Answer 1

The wash sale rule only applies when the sale in question is at a loss. So the rule does not apply at all to your cases 3, 4, 7, 8, 11, 12, 15, and 16, which all start with a gain. You get a capital gain at the first sale and then a separately computed gain / loss at the second sale, depending on the case, BUT any gain or loss in the IRA is not a taxable event due to the usual tax-advantaged rules for the IRA.

The wash sale does not apply to "first" sales in your IRA because there is no taxable gain or loss in that case. That means that you wouldn't be seeking a deduction anyway, and there is nothing to get rolled into the repurchase. This means that the rule does not apply to 1-8. For 5-8, where the second sale is in your brokerage account, you have a "usual" capital gain / loss as if the sale in the IRA didn't happen. (For 1-4, again, the second sale is in the IRA, so that sale is not taxable.)

What's left are 9-10 (Brokerage -> IRA) and 13-14 (Brokerage -> Brokerage).

The easier two are 13-14. In this case, you cannot take a capital loss deduction for the first sale at a loss. The loss gets added to the basis of the repurchase instead. When you ultimately close the position with the second sale, then you compute your gain or loss based on the modified basis. Note that this means you need to be careful about what you mean by "gain" or "loss" at the second sale, because you need to be careful about when you account for the basis adjustment due to the wash sale.

Example 1: All buys and sells are in your brokerage account. You buy initially at $10 and sell at $8, creating a $2 loss. But you buy again within the wash sale window at $9 and sell that at $12. You get no deduction after the first sale because it's wash. You have a $1 capital gain at the second sale because your basis is $11 = $9 + $2 due to the $2 basis adjustment from wash sale.

Example 2: Same as Example 1, except that final sale is at $8 instead of at $12. In this case you appear to have taken a $2 loss on the first buy-sell and another $1 loss on the second buy-sell. For taxes however, you cannot claim the loss at the first sale due to the wash. At the second sale, your basis is still $11 (as in Example 1), so your overall capital loss is the $3 dollars that you might expect, computed as the $8 final sale price minus the $11 (wash-adjusted) basis.

Now for 9-10 (Brokerage->IRA), things are a little more complicated. In the IRA, you don't worry about the basis of individual stocks that you hold because of the way that tax advantages of those accounts work. You do need to worry about the basis of the IRA account as a whole, however, in some cases. The most common case would be if you have non-deductable contributions to your traditional IRA. When you eventually withdraw, you don't pay tax on any distributions that are attributable to those nondeductible contributions (because you already paid tax on that part). There are other cases where basis of your account matters, but that's a whole question in itself - It's enough for now to understand 1. Basis in your IRA as a whole is a well-defined concept with tax implications, and 2. Basis in individual holdings within your account don't matter.

So with the brokerage-IRA wash sale, there are two questions: 1. Can you take the capital loss on the brokerage side? 2. If no because of the wash sale, does this increase the basis of your IRA account (as a whole)? The answer to both is "no," although the reason is not obvious. The IRS actually put out a Special Bulletin to answer the question specifically because it was unclear in the law.

Bottom line for 9-10 is that you apparently are losing your tax deduction completely in that case. In addition, if you were counting on an increase in the basis of your IRA to avoid early distribution penalties, you don't get that either, which will result in yet more tax if you actually take the early distribution.

In addition to the Special Bulletin noted above, Publication 550, which talks about wash sale rules for individuals, may also help some.

Answer 2

Brokerage->Brokerage 13-16

13. The loss from the previous purchase will be added to the cost basis of the security for the second purchase. Since you sold it at a loss again it would increase your losses. Your loss from the first sale will be disallowed.

14. Your loss will be added to the cost basis of the next purchase. Your gains will be taxed on the total of the cost basis which will reduce your gains. Which you will taxed 'less'.

15. Your gains will be taxed. Your loss is allowed.

16. You will be taxed on both.

Wash Sales really only applies to losses. If you sell for gain, the tax man will be happy to take his share.

From my understanding, it does not matter if it is IRA or Brokerage, the wash sale rule affects them all.

Check this link: http://www.marketwatch.com/story/understanding-the-wash-sale-rules-2015-03-02