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Tuesday, April 15, 2008

The Dreaded Wash Sale Rule

It's tax time and you are a fledgling investor. You've been dabbling in the markets trading various securities, even options! During all this activity you might have heard about something called a wash sale. But did you really pay attention? Nope! You thought, "Meh, I'll worry about that later. I've got a general handle on what it means. Back to trading!" And then tax time hit.......

This post might be too late for some of you, seeing how it is the 11th hour. But just in case, I thought I'd provide a little insight. A wash sale is defined by the IRS Publication 550 as follows:

A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:
  • Buy substantially identical stock or securities,
  • Acquire substantially identical stock or securities in a fully taxable trade, or
  • Acquire a contract or option to buy substantially identical stock or securities
What is meant by substantially identical? Typically it means buying the same security. And yes, that includes options on that security! Doesn't that suck? Yeah... tell me about it.

Why is this rule in effect? It is there to dissuade people from selling and buying a stock just to get the the loss write off. See, if you take a loss on an investment, the IRS has a provision that allows investors to deduct the loss come tax time. BUT... if you try to game the system, the IRS sticks it to you. When a wash sale occurs, you cannot deduct the loss.

What can you do? You add the loss into the cost basis of the shares of stock you bought back within that window. Oh, and you have to add them proportionately. Say for instance you sold 100 shares of XYZ at a loss and bought 150 shares of XYZ within a 30 day window prior to or after selling those first 100 shares. The loss you just incurred is considered a wash. That's right, you can't deduct that loss! BUT, you can apply that loss to the cost basis of 100 of the 150 shares of XYZ that you bought.

So what does this mean? It means you haven't lost the chance to deduct the loss; you only have to be a little more patient. By allowing you to add the loss to the cost basis of the new shares, the IRS gives you the opportunity to take the loss later -- that is if the new shares are also sold at a loss.

Okay, so you have a problem. You need to determine whether or not you have a wash sale. You now know that a wash sale occurs when there is buying and selling of the same security, whether it be purely stock, options, or any combination, within a certain 30 day window. What happens if I buy a stock and options on that stock on the same day and both are sold within 30 days of the buying and the selling...... Specific ain't it? Yes, that's what I did. And I thought I was in a Catch 22. Why? Because if you take the wash sale terminology word for word, it may seem like you are screwed and cannot take any loss. It would sound like this:

  • Bought 100 shares of stock XYZ and 2 Call option contracts on stock XYZ on Day 1
  • Sold 100 shares of stock XYZ on Day 10 at a loss
  • Did I buy substantially identical stock within a 30 day window? Yes, the options.
  • Loss in sale of stock XYZ on Day 10 is a wash
  • Add cost basis of shares of XYZ to equivalent number of shares in the options contract ( so to one of the two contracts since each contract holds 100 shares )
  • Both XYZ call options expire at a loss on Day 25
  • Did I buy substantially identical stock within a 30 day window? Yes, the stock.
  • ....WHAT!? Is my loss on the options a wash too!?
No! You are safe. You've already taken into account the stock. The number of shares in that stock you sold at a loss no longer exist and the loss has been added to the cost basis of the options. So when you ask the 30-day window question about the options, the stock that you sold earlier is no longer in the picture as it has already been accounted for.

Okay, now there are several rules for wash sales. It gets pretty hairy, believe you me. And if you have a lot of complex situations like the one above (combinations of options, stock, and maybe other stuff), or a high frequency of trades, then doing this by hand is NOT an option. You want to use a program. I've done this research so you don't have to anymore. Check it out:

Where can I get software to do these calculations and generate Schedule D's?

GainsKeeper: Handles the simple stuff. Does NOT support wash sale determination when it involves the combination of stock and options: "GainsKeeper does not adjust for wash sales across long and short holdings. Nor will GainsKeeper generate a wash sale if you sell an equity at a loss, and then open a call option for the same equity within the wash sale window." GainsKeeper is a web application with an online interface that can electronically aggregate your data from any number of brokerages you may have. It has a 30-day free trial.

TradeLog: Handles the complex stuff. DOES support wash sale determination when it involves the combination of stock and options. It also handles rules regarding puts, shorts, etc. It is said that TradeLog applies the most stringent rules so as to catch any possible condition of a wash sale. So if you want to be safe, use TradeLog. This is a downloadable application and also supports download of data from any number of brokerages you may have. It has a free trial as well (see the right most bar on the that page). This is a FREE online calculator. It seems very sophisticated and boasts 6 configurations for calculations. These configurations depend on the complexity of your situation. Configuration 6 is the catch all and, some say, is the configuration that TradeLog uses. To use the calculator you must register. Once registered, you can upload your information.

All of these solutions generate Schedule D's. However, is the only one that will do it for free. So what kind of pinch are you in?

By the way, does Turbo Tax Premiere adequately determine wash sales? I can't say for certain, but it DOES use GainsKeeper. And we know from the GainsKeeper website that GainsKeeper does NOT handle the more complex wash sale triggers.....

I hope this helps! Ganbare!

Other links:

Tuesday, March 18, 2008

Bear Stearns for $2 may not hold?

In my previous post I asked the question, how is Bear Stearns trading above $2 when the deal on the table is for $2 a share. SmartMoney has an article that brings some light to the situation. Obviously this offer is just cold to the bone! There is much more behind the scenes concerning why, especially regarding the repercussions of the alternative - bankruptcy. Anyway, the shareholders who are getting the major screw are not happy and it sounds like they will fight this price. Since the process of closing the deal could drag on for 12 months, the likelihood of forcing the offer to increase may be pretty good, especially since JP Morgan is guaranteeing all of Bear's trading activity within the firm for the entire period the deal is being negotiated. What does this mean? Well, it means that Bear Stearns can still do business! That is if other investment houses trust JP Morgan's guarantee and continue to trade with Bear (note that it was the pulling out action of counterparties last week that also hurt Bear, further deterioting confidence in the firm). So, if Bear can still operate, there is a possibility it can fix its financial situation, get back to stability, and maybe even start tearing a new path on the street. In that event, Bear would be worth more. It's now trading at $6.80. Those who bought yesterday have doubled!

Monday, March 17, 2008

Talk about a swing!

Early this morning I noticed, on my Google Sidebar, that premarket trading indicated stocks were about to get hit... BIG time. I wondered, "Whoa! What could be going on to elicit such a reaction!?" So I whipped open Google Finance and behold the word was in, JPMorgan Chase is buying Bear Stearns for $2 a share. WHAT!? Yes people, JPMorgan somehow put together a deal to buy one of the top tier Investment Banks in the country for ONLY $2 a share! Needless to say, the stock price of Bear plummeted to $3 and change for an 80-90% drop in price after Friday's close. If that wasn't bad enough, note that this stock was trading in the $60 - $70 range last Monday... exactly one week ago. It dropped to the upper $20s and low $30s last Friday. And again, I tell you, it's now at $3 and change.

JPMorgan Chase pretty much scored the deal of the year, that is if it can weather the financial difficulties Bear is fighting off to make it worthwhile. Much of the plunge in the stock during last week seemed to be due to rumors that lead people to head for the hills, at least according to Bear CEO Alan D. Schwartz. Check out this BBC article for more detail. Nevertheless, the price dove and the Fed was not having it. Both the Fed and JPM stepped to the plate.

Here are some questions. If JPMorgan Chase is buying Bear Stearns for $2 a share, how is Bear's stock trading above $2? Is this a short arbitrage opportunity? And what about the larger more looming question of, how in the WORLD does a top tier company like Bear go from a 52-week high of $158.36 to $3 and change? And especially since about half of that happened in 7 days! But wait, check this... what's even scarier is that apparently the way in which the Fed stepped in to help Bear is reminiscent of the ways in which the Fed stepped in to help organizations during the Great Depression.... that is according to this article from Reuters. Resorting to measures that haven't been used since the Great Depression..... WHOA!

There are tons of articles on the web about this incident. Do a Google search; there will be no lack of its abundance. Just watch out for the people trying to spin this out of control crying doom and gloom. Yes, it's alarming. What should you do? Be careful out there. More importantly, stomp out the Greed bug. The market is tremendously volatile right now. If you are trading, get in and get out. Be happy with any profit you make. Those of you trusting your 401K retirement funds to some mutual fund manager.... you better pay attention to what's going on. There is no such thing as a free lunch and there is no genie out there. Bear is 77% institution owned according to Google Finance. That means a lot of the big boys hold this stock, including without question SEVERAL mutual funds. And nearly all 401Ks invest in mutual funds. I mean come on, who would expect a top tier Investment Bank to suddenly plunge.... Be careful out there.

Oh, and for you conspiracy theorists.... this article from the should prove mighty interesting. Somebody made a lot of money....