It's hard to believe, I know, but there may be times when you buy a stock, mutual fund, or other security and it (wait for it...) goes down! No one wants to own something that is down, but there's a bit of good news. By selling the security, you will realize the losses, creating tax losses to offset gains. The amount that you can deduct depends on your tax specific tax situation.
Of course, saying that selling securities at a loss for the tax benefit is good news is kind of like saying that selling for a gain is bad news because you will have to pay taxes. Yes, we would rather have the gains and the taxes to pay, but I'm looking at the silver lining here folks.
Let's do an example. You bought a security for long term investment purposes. Let's say it was a stock, let's call it 1,000 shares of Coca-Cola (KO). We're going to presume that you are not an active trader, because that would complicate things. It goes down, let's say from $65 to $54 per share. Your 1,000 shares has lost $11,000.
You're not going to bail on the stock because you're a long term investor. You're not going to buy more to "average down" because that's foolish. You simply want to continue to hold it. Of course, you want the tax loss, but in order to get that you have to sell it. You could always sell it, take the tax loss and buy it back again, but then you run smack into what the IRS calls a "wash sale."
Here's how it works.
In the event that a loss is claimed resulting from the sale of securities, and within 30 days before or after that sale, the taxpayer acquires or enters into an option or contract to acquire "substantially identical" securities, no tax loss deduction is allowed.
What does that mean? Well, the tax loss resulting from your sale of Coca-Cola is not valid if, like I suggested earlier, you buy it back within 30 days. The answer seems easy. Sell the shares, wait 30 days and buy them back. But there's a problem. The goal is continued long term exposure. Not timing the market; not active trading. If you want continuous long term exposure to Coca-Cola, being out for 30 days is not continuous.
Thirty days may not seem like that much, but history has shown that big single day price moves can have an enormous impact on long term returns. Besides, have you seen the movie Super Size Me? This guy eats nothing but McDonald's for 30 days, and his body nearly shuts down on him. Thirty days can be an eternity.
An alternative is to buy something else. But what do you buy? Pepsi? Same industry stocks tend to have similar price movements. Are they substantially identical? Millions of devout Coke drinkers would certainly say no. And it seems that the IRS would agree with them.
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