After a year like we had last year, every investor should know about the Wash Sale Rule.   Regardless of whether your overall return is positive or not, it makes good sense to sell those holdings that you have experienced a loss so that you can use that loss to offset other gains in your portfolio- thereby reducing your overall tax obligation.   The less cash you need to shell out to the government, the more you get to keep.

The Wash Sale Rule prevents you from selling your stock or mutual fund for a loss and then turning around and buying “a substantially similar” stock or mutual fund within 30 days before or after your sale.  If you do, your loss will be invalidated and you will be forced to pay the additional taxes.

Ok, this seems clear, so what does it mean in practice?  Let’s look at a few examples.

1. I sold my stock in Apple because I am worried about their high P/E ration, but I think computer hardware is due for a rebound in 2010 and think that Dell has been oversold. According to Wash Sale Rule expert, Kaye Thomas, you are allowed to replace one company with another even if they are in the same industry.  After all, we all know that an iPod is VERY different from, say, a Dell DJ.   As she explains:As a general rule, stock of one issuer isn’t substantially identical to stock of a different issuer, even if they are in the same industry. For example, Dell isn’t substantially identical to HP. If you have a loss on one of these companies, you can buy the other one without having a wash sale.
2. I sold my S&P Index Fund but think that the bottom is near and want to buy another, lower-cost S&P Fund.  Is this ok? The short answer is “No.”  A good rule of thumb, according to Ms. Thomas, is to overlay the performance of the two mutual funds or ETF’s and see how they perform compared to one another.  If they tend to move in lock-step, you most likely have “substantially similar” holdings.   As she explains further:The point of the wash sale rule is to determine whether you’ve changed your position relative to the market. If you can lay the price graph for your new investment on top of the price graph for the old one and never see a significant disparity (as would be the case for two high quality S&P 500 funds), the investments should be considered substantially identical for purposes of the wash sale rule.
   
3. I sold my Asian ETF held in my brokerage account but told my wife to buy a replacement for it in her IRA?  Is this allowed? If someone is related to you or an entity owned by you- such as your Roth IRA- buys a “substantially similar” security, you would be in violation of the Wash Sale and you could not take the loss.

You can read more about the Wash Sale Rule here, here and here.