What's the point of the wash rule?

Question

I don't understand the 30-day wash-rule. Someone please set me straight.

So let's say I purchase 100 shares of Hot Stock X, for $100 apiece. So $10,000.

Let's say that the stock goes down 50% on a really bad day in the market.

Let's say furthermore that the 30-day wash rule doesn't exist.

So I sell my 100 shares at a 50% loss, I claim a capital-loss of $5,000 dollars, and then a minute later, I repurchase 100 shares for the exact same price I sold them at.

Hot Stock X goes back up to $100 the next day on a really good day in the market. I then sell my position. So in a world without the wash-rule, I'm back to my original $10,000. I haven't lost or gained a penny, but I've "mined" a capital loss of $5,000 dollars out of thin air.

Except that I haven't of course, because after I bought the 100 shares the second time when they were down and rode the market back up the next day and sold, I recorded a capital gain on that trade of $5,000. So the capital-loss of $5,000 cancels out this capital gain completely. I've made no money in this case, and I have no capital loss to game the system with.

So what's the point of the wash-rule anyway? I read about loss-harvesting where you purposefully incur your loss and then repurchase the same securities on the 31st day afterward, but vis-a-vis this example, I can't understand what the point of that would be, nor indeed what the point of the wash-rule is to begin with. The capital gains you make on a security cancel out the capital-losses that you intentionally tried to "harvest". What am I missing?

Answer 1

The point of the wash rule is to defer (not eliminate) the tax benefit of a sale until you close out the position that you opened after realizing the loss. In your example, you closed your re-opened position on the next day (presumably in the same tax year), so the cost basis of that second position is the original purchase price ($10,000) because of the wash sale rule, and you have made no profit. It is the same as if the wash rule did not exist, in which case the $5,000 loss would cancel the $5,000 gain.

However, suppose the second sale was in a different tax year. You would then be able to claim a $5,000 loss in one tax year and a $5,000 gain in another. Yes you would still pay the tax on the gain, but a year later. You're effectively "borrowing" the tax benefit from the government.

The wash rule prevents you from artificially lowering your current tax bill without changing your overall investment position. Again, it only defers the tax benefit. It does not eliminate it.

Answer 2

The point of the wash trading rule [and similar variations in different jurisdictions] is to prevent someone from deferring gains and accelerating recognition of losses, for tax purposes.

Without a similar rule, the ideal tax management plan would be as follows:

Assume you have a portfolio of 10 stocks which you intend to hold until retirement in 20 years. In year 1, assume 4 stocks declined by 10%. So you sell those stocks on Dec 31, and immediately rebuy them. Your portfolio is identical on Jan 1, but you have now realized, say, 10k in losses [even though your total portfolio is up by, say, net 15%]. So you get the tax benefit of those losses immediately [either against other gains you already realized, or against other income small bits at a time, in the US].

In year 2, one of your chosen stocks has a sharp decline of 30%. You sell and repurchase. Again, recognizing that loss, and getting the tax benefit. Similar scenarios in year 3, 4, etc..

By year 5, everything in your portfolio is up from its original cost [or, up from the lowest point at which you sold]. And 15 years later, you start to sell stocks in your retirement years to fund your living expenses, at which point you finally start recognizing taxable income.

Wash rules prevent you from manipulating your stock portfolio to accelerate recognition of tax losses and defer recognition of tax gains.

Things actually can get very, very silly in a 'perfectly managed' portfolio: Don't buy a stock index, buy every stock individually yourself. Every day, sell and rebuy the losers. Never sell the winners. Ignoring transaction costs, you would constantly have tax losses and the benefits thereof - and even though your actual market risk is identical to someone who bought the index, you would get 'free' reduction in your taxable income.