by David N. Eich - February 12, 2008
TradeLog® is one of the only wash sales / schedule d software programs to even attempt to calculate wash sales between what the IRS refers to as "substantially identical" stock or securities. So if you trade options, or stocks and options on the same underlying stock or security and incur losses, you may have a wash sale problem.
Stocks and Options
One common scenario is: You bought and sold 100 shares of Apple Inc. (AAPL) at a loss and then buy an
AAPL option within 30 days of your stock loss.
IRS
publication 550 views this
as a transaction to "acquire a contract or option to buy substantially
identical stock or securities." Notice that It says nothing about
the expiration month or year, the strike price, or whether it is a put or a
call. But it has everything to do with the underlying stock or security of the
option contract.
This creates a wash sale which in turn disallows the loss on the stock transaction. And according to the wash sale rule you have to add the disallowed loss from the stock transaction to the cost of the option.
Now let's reverse that. Let's say you bought and sold one contract of an AAPL option and took a loss on the trade and then you buy 100 shares of APPL within 30 days. Once again, you have created a wash sale and your loss on the option trade is disallowed according to the wash rule and you need to adjust you cost basis on the stock trade.
But there are many other scenarios when trading options that trigger the wash rule. Some of the more common are:
Option Holders
Many option traders purchase put or call options hoping to cash in on short
term trends while minimizing their risk. But losses are inevitable as no
trader is 100%. So if you close a long option trade at a loss and then
purchase another option on the same underlying stock within the 30 day
window, you have triggered a wash sale and the loss on the sale of the
option is disallowed.
Option Writers
Other option traders like to sell options either covered or naked. In this
case you did not purchase an option, you sold an option. Here is where the IRS rules for short sales come into play.
IRS publication 550 page 56 states:
"The wash sale rules apply to a loss realized on a short sale if you sell, or enter into another short sale of, substantially identical stock or securities within a period beginning 30 days before the date the short sale is complete and ending 30 days after that date."
Once again, notice the words "substantially identical." You sold an option, bought it back at a loss and then sold another option on the same underlying stock. Both options are considered "substantially identical" securities. This creates a wash sale which disallows the loss on the first option.
Covered Call Writers:
Writing covered calls is quite a popular strategy among options traders, but
often creates similar wash sale problems.
For example, you buy 1000 shares of AAPL and then sell 10 contracts of an AAPL call option for a nice premium. The stock moves against you so you close your call option at a loss and then sell the next month out AAPL option. You just created a wash sale and your loss on the first option is disallowed. The loss increases your cost basis of new short option position and is realized when you finally close the position.
Now, what if you sell your 1000 shares of AAPL at a loss? If you bought back some of those AAPL shares or bought an AAPL option within +/-30 days, you generated another wash sale. If you buy back less than the 1000 shares, or buy less than 10 contracts, only part of your loss is disallowed.
Next please consider the minus 30 day part of the wash sale rule, where you have to look 30 days backwards, as well as forwards to spot potential disallowed losses and cost basis adjustments. In exactly what order do you put these in before you start to apply these rules? Once again, no clear guidance from the IRS.
Oh, by the way, many brokers report option trades using only the option ticker symbol and or using a stock description and do not provide the underlying stock ticker as they do with stock trades. So the onus is on you the trader to properly report these on your schedule d.
Can you see how horribly complex this whole issue is? This is probably why most other trader tax software programs ignore the problem.
We however, chose to tackle the problem of wash sales across "substantially identical" securities making our TradeLog® software the most IRS compliant trader tax lot accounting program on the market.