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I understand the basics of what a wash sale is, and in particular that it prevents an investor from realizing a capital loss through a temporary sale of a security in order to offset a capital gain. However, after much Googling I'm unable to understand the justification for the rule. Why does it exist?

Note that "to keep an investor from lowering their tax bill" is not an explanation. There are lots of things investors can do to lower their tax bill and they aren't all outlawed. Ideally, tax law is designed to collect the appropriate revenue from the appropriate people (or disincentivize undesirable behavior) while minimizing market distortions.

If an investor makes $X in one year and loses $X in another year, there's nothing untoward about them trying to move those into a single year so that they cancel and no taxes are owed. (Zero taxes makes sense when there are zero net gains; this is the justification behind all sorts of exemptions that carry-over from year to year.) But currently, if I realize a capital gain in the first year and I've also got an unrealized capital loss in another security, I'm forced to either pay taxes that year despite zero expected gain or to reduce my exposure to the loosing security for at least 30 days. Why inflict this distortion? What behavior is trying to be prevented?

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    Attempting to discern a rationale for any component of the US code, including the tax code, is properly a political question. Once enacted, "it is what it is". – user662852 Apr 7 '17 at 13:48
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In a comment on this answer you asked

It's not clear to me why the ability to defer the gains would matter (since you never materially benefit until you actually sell) but the estate step up in basis is a great point! Could you describe a hypothetical exploitive scenario (utilizing a wash sale) in a little more detail?

This sounds like you still have the same question as originally, so I'll take a stab at answering with an example.

I sell some security for a $10,000 profit. I then sell another security at a $10,000 loss and immediately rebuy. So pay no taxes (without the rule). Assuming a 15% rate, that's $1500 in savings which I realize immediately. Next year, I sell that same security for a $20,000 profit over the $10,000 loss basis (so a $10,000 profit over my original purchase). I sell and buy another security to pay no taxes. In fact, I pay no taxes like this for fifty years as I live off my investments (and a pension or social security that uses up my tax deductions). Then I die. All my securities step up in basis to their current market value. So I completely evade taxes on $500,000 in profits. That's $75,000 in tax savings to make my heirs richer. And they're already getting at least $500,000 worth of securities.

Especially consider the case where I sell a privately held security to a private buyer who then sells me back the same shares at the same price.

Don't think that $10,000 is enough? Remember that you also get the original value. But this also scales. It could be $100,000 in gains as well, for $750,000 in tax savings over the fifty years. That's at least $5 million of securities.

The effective result of this would be to make a 0% tax on capital gains for many rich people.

Worse, a poorer person can't do the same thing. You need to have many investments to take advantage of this. If a relatively poor person with two $500 investments tried this, that person would lose all the benefit in trading fees. And of course such a person would run out of investments quickly.

Really poor people have $0 in investments, so this is totally impractical.

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'Note that "to keep an investor from lowering their tax bill" is not an explanation'. Well, yes it is. In fact it is the only explanation.

The rule plainly exists to prevent someone from realizing a loss when their economic situation remains unchanged before/after a sale. Now, you might say 'but I have suffered a loss, even if it is unrealized!' But, would you want to pay tax on unrealized gains? The tax system still caters to reducing the tax impact of investments, particularly capital investments. Part and parcel with the system of taxing gains only when realized, is that you can recognize losses only when realized.

Are there other ways to 'artificially' reduce taxable income? Yes. But the goal of a good tax system should be to reduce those opportunities. Whether you agree that it is fair for the government to prevent this tax-saving opportunity, when others exist, is another question. But that is why the rule exists.

  • Well, the fact that wrote your second paragraph shows that "to keep an investor from lowering their tax bill" is not a sufficient explanation. Indeed, you point toward an interesting feature not encoded in such a flippant statement: the asymmetric incentives facing an investor toward unrealized gains and losses. Unfortunately this isn't enough since there is another key asymmetry that motivated carry-overs in the first place: that you pay taxes on gains but don't receive negative taxes on losses. Equal sized gains and losses in alternating years would lead to an unjust positive tax. – Jess Riedel Apr 7 '17 at 13:45
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    @JessRiedel I think you have a misunderstanding of the tax code. Losses can be applied against other years where gains are present. – Grade 'Eh' Bacon Apr 7 '17 at 13:49
  • Sure, this ameliorates the effect but it's very imperfect because you can't carry losses backwards to previous year tax return (which is exactly the case when a wash sale would be useful and just) and there are limits on the dollar amounts and number of years. – Jess Riedel Apr 7 '17 at 13:55
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    50% of the time, this law reduces taxes for investors. The other 50% of the time, you still have the ability to sell your stock to create the loss you desire. Fundamentally, if you are looking to argue the merits of the law itself, or how to construct a "fair" tax system (whatever that means), this site is not the best place for it. – Grade 'Eh' Bacon Apr 7 '17 at 13:59
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    "Sure, this ameliorates the effect but it's very imperfect because" Show me a single sentence from the tens of thousands of pages of tax code that's perfect... It seems like you're just here for an argument. – quid Apr 7 '17 at 17:14
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Overall the question is one of a political nature.

However, this component can have objective answers:

"What behavior is trying to be prevented?"

There are mechanisms by which capital gains can be deferred (1031 like-kind exchange, or simply holding a long position for years) or eliminated by the estate step up in basis. With these available, mechanisms that enable basis-reduction are ripe for abuse.

On the other hand, if this truly bothers you then if you meet the IRS qualifications of a day trader, you may elect to use "mark to market" accounting, eliminating this entirely as a concern.
Special rules for traders of securities

  • Thanks! This is close to completely answering the question. It's not clear to me why the ability to defer the gains would matter (since you never materially benefit until you actually sell) but the estate step up in basis is a great point! Could you describe a hypothetical exploitive scenario (utilizing a wash sale) in a little more detail? – Jess Riedel Apr 7 '17 at 14:20
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"Equal sized gains and losses in alternating years would lead to an unjust positive tax."

On the contrary. If I can take my gains at the long term rate (15%) in even years, but take losses in odd years, up to $3000, or let them offset short term gains at ordinary rate, I've just gamed the system.

What is the purpose of the wash sale rule?

Respectfully, we here can do a fine job of explaining how a bit of tax code works. And we can suggest the implication of those code bits. But, I suspect that it's not easy to explain the history of particular rules. For wash sale, the simple intent is to not let someone take a loss without actually selling the stock for a time. You'd be right to say the +/- 30 days is arbitrary.

I'd ask you to keep 2 things in mind if you continue to frequent this board -

  • These kinds of questions are frequently closed as off topic. As I see comments accumulating, it's easy to see how they are easily turned into opinion, a debate, or worse, a political discussion.
  • The one you chose is interesting, not just to you, but to all of us who have been caught by this rule. But, it's not the only one, it's one of hundreds. I could literally list 2 dozen rules within our code that has me scratch my head, or worse, say,"wow, I learned this, and benefited, but how would the average person know this particular thing." The list has no place here, but there's a chat area, and we can 'get a room' for that very topic.
  • My comment elsewhere answers your first criticism. Regarding whether the question has an answer: note that a similar question has a specific answer: "Q: What is the purpose of the gift tax, and why is the max rate 40%? A: to prevent parents from going around the estate tax.". How is one supposed to determine whether my question has an analogously good answer or not until it is asked? I'm happy if my question has few votes because it doesn't generate good answers, but the existence of the question is still useful for documenting this. – Jess Riedel Apr 7 '17 at 14:27
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    If user662852's answer suffices for you, that's great. – JoeTaxpayer Apr 7 '17 at 14:35
  • I welcome any advice on how I could have asked this question differently that would have elicited his answer while minimizing discussion. (It's hard!) – Jess Riedel Apr 7 '17 at 14:37
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    Yes, it is. User hit it perfectly. Instead of the phrasing "what is the purpose" which obviously runs afoul of your note to avoid "to avoid citizens saving on tax bill", he focused/rephrased to "what actions does this law avoid/prevent, and why"? With over 10,000 questions, you can see there are those that are very straightforward / on topic, and those that are in the grey area. Fine line sometimes. – JoeTaxpayer Apr 7 '17 at 14:42

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