It’s an inconvenient truth for brokers that the IRS asks them to report wash sale losses on 1099-Bs differently from the way traders must report wash sale adjustments on income tax returns. Brokers are correct in preparing 1099-Bs, but incorrect in telling clients they should import 1099-Bs into their income tax filings.
Securities brokers asked for my content
Here is some background information. Leading online brokers, and a media outlet sponsored by a leading broker, engaged me to contribute content about wash sales. A securities broker asked me to contribute another tax article to their newsletter for active traders. I contributed an article, similar to my recent blog post “Wash Sale Loss Adjustments Can Be A Big Tax Return Headache.” A financial network, broadcast over the Internet, asked me to contribute trader tax content, including content on wash sales. Other brokers requested similar content.
My content states: Brokers calculate wash sales based on identical positions (an exact symbol only) per separate brokerage account. But the wash sale loss rules for taxpayers, Section 1091, requires taxpayers to calculate wash sales based on substantially identical positions (between equities and equity options and equity options at different exercise dates) across all their individual accounts including IRAs — even Roth IRAs.
Business managers quashed my editorial content
An odd thing happened. The brokers and media editorial departments approved my content for dissemination. Afterwards, business managers quashed or watered down my content. Editors told me their business managers said: Why should our editorial content advertise this wash sale loss problem, when our profit and loss reports, and 1099-Bs are not compliant with Section 1091 wash sale rules for taxpayers? Business managers advertise that clients can download 1099-Bs into tax preparation software, making tax filings easy. My content on wash sales exposed that marketing myth as a falsehood.
While in the short-term, they may avoid the wash sale loss problem, over the long-term, it will not work out well for the brokers or the clients. The IRS will probably audit some of their clients over wash sales and agents will likely propose tax changes, including tax liability, penalties and interest. Clients will surely be upset with their brokers for not informing them about this problem and leading them astray.
How to avoid wash sale loss problems
There are several ways to avoid wash sale loss problems, but a trader must first know they have a problem. Consider these examples:
-Most clients do not understand that a wash sale loss between a taxable account and an IRA, including a Roth IRA, is permanently lost. You will never get that tax loss on your tax returns or inside your IRA. That is different from a wash sale loss among taxable accounts, which is a deferral at year-end. With deferral, the trader can get the tax loss in the subsequent tax year in his taxable account. To avoid wash sale losses with IRAs, traders should create “Do Not Trade” lists between individual taxable and IRA accounts.
-Active traders, qualifying for trader tax status, should consider making a timely Section 475 MTM election, on securities only, to be exempt from wash sale loss adjustments on those Section 475 trades. Section 475 is ordinary gain or loss treatment, which means those trades are exempt from the $3,000 capital loss limitation against other income.
-Trade Section 1256 contracts, which are exempt from wash sale loss rules. Tax filings are truly a snap with Section 1256 contracts, reported on a one-page 1099-B. They include futures, broad-based indexes and non-equity options. Section 1256 contracts also have lower 60/40 capital gains tax rates, with 60% being a long-term capital gain. Section 1256 contracts have mark-to-market accounting built-in, negating the need for wash sale loss adjustments.
-Approaching year-end, clients should assess potential wash sale losses. They can ‘break the chain’ on wash sales, by selling open wash sale loss positions and not buying substantially identical positions back for 31 days. The wash sale melts away with the full tax loss realized in the current tax year.
-Trade securities in retirement accounts, only, so you do not have to worry about wash sale loss adjustments with taxable accounts.
Use trade accounting software, compliant with Section 1091
There is a good solution for taxpayer wash sale loss reporting and management. Trade accounting software for downloading original brokerage transactions and calculating wash sales, but, only if the software is compliant with Section 1091 wash sale rules for taxpayers. Only a few brokers offer tax-compliant software in their Website toolboxes.
Other brokers offer software that is non-compliant with Section 1091 for taxpayers. Those programs do not calculate wash sales between equities and equity options, like Apple stock with Apple options and at different expiration dates, in other words, on substantially identical positions. Non-compliant programs report wash sales between identical positions only, matching broker 1099-Bs. That compounds the problem and gives clients a false sense of security. Traders and tax preparers can make manual wash sale loss adjustments in non-compliant programs, but that’s very difficult when there is significant trading volume and frequency.
Complex trades in equity options require adjustments for offsetting positions
If you make complex trades in equity options, you may need to make tax adjustments for offsetting positions, like straddles. (Complex option trades known as “option spreads” include multi-legged offsetting positions like iron condors; butterfly spreads; vertical, horizontal and diagonal spreads; and debit and credit spreads.)
Broker 1099-Bs do not make adjustments for offsetting positions on complex trades in equity options. Most trade accounting software does not either. Manual adjustments are required and that can be difficult. If you qualify for trader tax status, consider a Section 475 MTM election, so open positions at year-end, including offsetting positions, are marked-to-market. That does away with the problem.
Join my effort to fix wash sale loss rules
The trading industry should not conceal this wash sale loss problem, by sweeping it under the rug. We should work together to ask Congress to fix the wash sale loss law.
I spoke with an attorney in charge of Section 1091 wash sale losses in the IRS chief counsel’s office, as well as an executive at a leading malpractice insurer for CPAs. Both of these officials reiterated there is only one-way to proceed: The right way, staying in compliance with Section 1091 rules for taxpayers.
