Year-End Tax Trading: Wash Sales and More

Traders speculating on market fluctuations often focus so closely on generating returns they forget something important: every trade has tax consequences. Often, traders are surprised by the unexpected complexity that can arise from what seems like a simple trading strategy. Let's look at a few most common taxes issues that can arise for traders.

No matter how good you are at trading, eventually you're going to realize a loss. It's just par for the course. In some situations, those losses can provide you with a tax benefit, offsetting other capital gains or even up to $3,000 of your ordinary income. However, due to the number of transactions most traders make, those losses can often be impacted by the wash sale rule.

The wash sale rule kicks in when you sell a security at a loss and then purchase the same or a substantially identical asset within 30 calendar days before or after the loss-sale date (a 61-day window). Once the wash sale rule is triggered, you're no longer allowed to use that loss to offset income. Instead, that loss gets added to the cost basis of the new shares you purchased. Basically, the current value of the loss is carried forward to a future date to be used to reduce your income down the road.

Not all assets are subject to the wash sale rule. The wash sale rule only applies to stocks, bonds, options, ETFs, and mutual funds, or options and futures contracts on those types of investments. Wash sales also apply to short positions that are closed at a loss. Other losses from assets like commodity futures contracts and foreign currencies are not generally impacted by the wash sale rule. Also, cryptocurrencies are not covered by the wash sale rule because the IRS has deemed them to be property, not securities (at least for right now). To learn more about the wash sale rules see, Watch Out for Wash Sales.

A constructive sale can occur when you take an offsetting position to an investment you currently own if that new position eliminates the risk of loss and the potential for further gains. Constructive sales often occur when a trader is trying to hedge an investment position against a market downturn. In certain situations, the IRS sees these hedges as a tax avoidance strategy. If that happens, the constructive sale rules kick in and the capital gain being protected by the hedge becomes taxable even though the position was never sold.

Here's an example of a constructive sale. Let's say you have 100 shares of ABC stock that had risen from $100 to $150, for an unrealized capital gain of $50 per share. If you short 100 shares of ABC to create a hedge where any price movement up or down no longer yields profit or loss, this creates a constructive sale. Once a constructive sale occurs, you must recognize the $50 gain and report that income on your tax return.

Needless to say, constructive sales rules are complex. They can be triggered by certain derivatives strategies; sometimes, a trade in an account held by another family member can be seen as a constructive sale. That's why we recommend working with a tax advisor and reading IRS Publication 550 to get a more comprehensive understanding of these rules.

It may seem logical to assume that shorting a stock is like buying low and selling high, but in reverse. Unfortunately, when it comes to the taxes, the IRS sees long and short positions a bit differently.

The main difference is that traders who have a short position don't generally own the shares they are shorting. Instead, they borrow the shares from a brokerage firm. To close out a short position and cover the trade, the trader needs to deliver an equal amount of shares to the broker.

From a tax perspective, the shares you deliver to close a short position determine whether you have a short-term or long-term capital gain or loss. For most traders, the shares used to close a short position are purchased in the open market at the time they want to end the trade, which means those shares were held short term. So that transaction will be taxed at ordinary income tax rates instead of the lower long-term capital gains rates.

For example, say Tom sold short 100 shares of XYZ stock in July of 2023 and then bought 100 shares of XYZ in September of 2024. He then delivered those shares to the broker to close out the short trade for a gain of $10,000. Even though the short position was open for over a year, that gain will be treated as a short-term capital gain and taxed at the ordinary income tax rates. The purchase date of the shares that Tom delivered to close the position determines if the gain is short term versus long term, not the dates that the trade was entered and closed. In this example, the shares were purchased and delivered in September 2024, making it a short-term position.

Suppose you own a portfolio of stocks that generate dividend income. If those shares are held within a margin account, the dividend payments you receive may be listed as substitute payments rather than as a dividend on your year-end tax forms. Substitute payments will be taxed at ordinary income tax rates rather than the more favorable qualified dividend rates. 

Why does this happen? If you buy a stock in a margin account, your broker can lend your shares to another investor who wants to short the stock. Although you're still long the stock position, you're no longer on record as the owner of that stock if someone else shorts it. If your stock pays dividends, the person who shorted the stock must compensate you with a cash payment equal to the amount of dividends you're entitled to. From a money standpoint, it's equivalent. But according to the IRS, you received a substitute for the dividend instead of the dividend itself, and those semantics make all the difference when it comes to calculating taxes owed. 

Meanwhile, the short seller can deduct the dividend payment made to the original owner (known as a short charge) as long as the position was held for at least 46 days. If you closed your position within 45 days or less, you'll have to add the amount of your dividend short charge to your buy-to-cover price. 

For example, suppose you short stock XYZ at $100 per share. XYZ pays a dividend of $1, and you forward that amount to the original stock owner. A month and a half later, XYZ falls to $90 per share and you buy-to-cover for a $10 profit. Because you held your short position for less than 46 days, you're unable to treat the $1 payment as an itemized deduction. Instead, you increase the cost basis of your short position, which reduces your profit by $1.

If you hold your stock in a traditional cash brokerage account rather than a margin account, the shares you purchase can't be loaned to short sellers, so you won't need to worry about substitute payments.

Do you trade futures, options on futures, or options on broad-based indexes, such as the S&P 500^® index (SPX) or Nasdaq-100^® (NDX)? For tax purposes, these assets are considered 1256 contracts, meaning that "mark-to-market" rules will probably apply. This means even if you didn't liquidate a position by the last trading day of the year, the IRS treats these assets as if you sold them on December 31 and uses that closing price to figure your gain or loss. That closing price is then used as the cost basis going forward into the next year. 

These contracts are given a somewhat favorable tax treatment under the 60/40 rule. This rule makes 60% of the gain/loss taxed at the lower long-term capital rates and 40% of the gain/loss treated as short term, so it is taxed at ordinary income tax rates. With a capital gains rates ranging from zero to 20%, mark-to-market securities can potentially offer a considerable tax savings compared with the maximum ordinary rate of 37% (as of 2024).

As a trader, taxes can be a bit more complex than for the average investor. To ensure you don't get stuck with an unexpected tax bill or miss out on any potential opportunities to reduce your taxes, we recommend meeting with a tax professional to ensure taxes don't derail you.