This is one of those “there but for the grace of God” stories, although it is not out of the question this tale may be quite germane and helpful to you in your lifetime: it has to do with the wash sale rule.
In case you are unacquainted with this bit of the tax code, it’s pretty easy to understand. Let me offer an example to illustrate its original intent. Let’s say you bought $50,000 of a stock which you intended to hold for a while. Unfortunately, the stock went to $40,000 in value, although you still had every intention to hang on to it. However, the end of the calendar year is approaching, so you decide to sell it, take the $10,000 loss for your taxes that year, and a few seconds later buy the stock back at almost exactly the same price. Thus, you still have the stock but you get to bank the loss straightaway.
Well, you can’t do that. You have to wait at least 30 days before you get back into the stock in order for the tax man to consider it a valid loss. Otherwise, the loss simply gets added back to the basis of your new purchase. In this specific instance, even though you spent $40,000 getting back into the stock, the $10,000 loss would be added to its basis, meaning whenever you sold it in the future, your cost basis would be $50,000. In other words, no harm, no foul. You don’t really make or lose anything, even though you don’t get to enjoy the loss like you intended. Doesn’t seem so bad, right?
Well, it usually isn’t, and normally wash sale rules hardly affect any traders to any meaningful degree, if at all. But there are definitely circumstances in which the strict application of the law can have horrific consequences.
Somewhere out there is a young man in this exact situation. Although his name has not been revealed, there are some things known about him. He’s 30 years old, and he makes $60,000 a year in the insurance business. About a year ago, when the lockdown was first starting, he decided to do what a lot of middle-income younger people did, which was to open up a Robinhood trading account and see what all the fuss was about. He scraped together $30,000 in savings and put it into his account and began his adventures as a day trader.
Plenty of younger people with a $30,000 account might divide it among three well-known stocks – – let’s say, Apple, Amazon, and Netflix – – and just be done with it. This fellow went hog wild, trading dozens or even hundreds of time per day. In spite of the very small account size, he amassed $45 million in trades for the year 2020. This may sound nuts, but I’ve done the same thing. Back in 2005 (I think it was) my trading account wasn’t that big, but I had almost a quarter billion dollars in trades. Insane, right?
Getting back to our insurance chap…………after those $45 million in trades, this fellow managed to clear a net profit of $45,000 for the year. I’ve got to say, in all honesty, that’s damned impressive. Let’s look at the facts:
- He made a 150% profit in less than a year;
- He did so as a day trader, which is typically the kind of activity the grinds accounts into hamburger;
- He managed to create profits equal to 75% of his gross salary
So………..hurray for this guy! A fantastic start!
Here’s the problem, though. He tax software ran his (enormous) 1099-B through the system, and it computed a tax bill of $800,000.
Huh? What? On $45,000 of gains? How is that even possible?
Remember the wash sale rule? That’s how it’s possible. Because if you are trading in and out of the same handful of symbols over and over and over again, EVERY loss you have is going to be disallowed, while EVERY gain you make will cheerfully be calculated as taxable. Nice of them, isn’t it? Thus, this poor son of a bitch has a tax bill equal to his gross salary over the course of 14 years. Jesus.
Now, theoretically, this fellow isn’t denied all those prior losses. They can be used in the future against future gains. Gains which haven’t taken place. And might never take place. And, screw the future, this poor bastard has a gargantuan bill RIGHT NOW which will grow by leaps and bounds thanks to interest and penalties. Sweet, right?
It isn’t fair, it isn’t right, and it makes no sense. I have no idea what’s going to happen to this fellow, but I seriously hope that someone in authority recognizes the very special circumstances of this situation and works something reasonable out with this guy. I feel sorry for him. But I at least wanted to share this tale with you, just in case you decide it’s a great idea to activity trade a few symbols, because it can seriously bite you in the ass and leave a terrible mark.