For a common investor, understanding wash sale and how one can leverage a loss to some profit is some daunting task. lets try to demystify wash sale for us 'common investors'.
The wash-sale rules comes into play if you sell a security and, within 30 days before or after the sale, buy a "substantially identical" security. Violate that rule and the loss on the first sale is denied.
Most of us have some securities whether it is a mutual fund, stock or etf which are in red since the market meltdown. Now as recessionary fear seems to be abating and stocks appear to be cheap, it seems to be a best time to do some tax loss harvesting.
For many investors, tax gain/loss harvesting is the single most important tool for reducing taxes now and in the future. If properly applied, it can save you taxes and help you diversify your portfolio in ways you may not have considered. Although it can't restore your losses, it can certainly soften the blow. For example, a loss in the value of Security A could be sold to offset the increase in value of Security B, thus eliminating the capital gains tax liability of Security B.
In a year like 2008 / 2009, almost no body should be paying any capital gain tax. If after selling securities either for profit or loss, you come up with a negative number, you can use up to $3,000 of those losses to offset ordinary income. And in many cases, you can carry over extra losses to subsequent years.
Example: Say I carry a Dreyfus mid cap index fund - PESPX and have a loss of $1000, I can sell it and using the proceeds can buy a not so substantially identical fund like Janus mid cap fund - JMCVX. This way I can reduce my tax liability by $1000 * my tax bracket. Point to note, I am still invested and my asset allocation is still intact. Replacing a index fund with active managed fund doesn't falls into the bucket of substantially identical fund and should not raise an IRS audit.
