Q         Dear Rick:

I think I made a mistake and I need your help in correcting it.  At the beginning of the year on a recommendation from a friend of mine, I bought a technology stock.  Unfortunately, since I bought the stock it has just gone down.  I originally paid $79 a share and when I sold the stock at the end of September, the stock was selling for about $40 a share.  My friend who gave me the recommendation to originally buy the stock told me that the stock was still a good buy and that I should immediately buy the stock back, which I did in the second week of October.  I was talking about what I did to a couple other friends of mine and they told me to my surprise that I would not be able to write off my losses from the sale of the stock because they said I violated some rule.  My question to you is did I violate a rule, will I have to pay penalties, and is there anything I can do to correct the situation?  I have never been in trouble with taxes and I want to do what I have to do to correct the situation.

Tammy

A         Dear Tammy:

Don’t worry, you’re not in trouble with the Internal Revenue Service and you don’t have to worry about any penalties.  That being said, there is an issue with regard to deducting the loss on the sale of the stock.

Under our tax laws we have what is known as the wash sale rule.  Basically, the wash sale rule prevents someone from deducting a loss on an investment that they sold and then immediately bought back.  The wash sale rule says that in order to deduct a loss on the sale of an investment, you cannot buy that investment or a similar investment, within a 30-day period.  The 30-day period is really more like 60 days because it includes 30 days before you sold the stock and 30 days after the sale.  The consequence of not complying with the wash sale rule is not a financial penalty or anything of that nature; rather, it means you are not allowed to deduct your loss on the original sale of the stock.

The loss from the sale of the stock is not lost in its entirety but rather, your cost basis is adjusted accordingly.  Sometimes taxpayers think they can outsmart the IRS and get around the wash sale rule if they buy the stock before the sale.  However, keep in mind the wash sale rule applies to purchases 30 days after the sale as well as 30 days before the sale.  However, one strategy that does work is, for example, say you had an emerging market stock fund that you had a loss in but at the same time you recognize that it’s important and good for the long-term health of your portfolio to maintain a position in emerging markets.  What you can do is sell one emerging market fund and then buy another emerging market fund immediately thereafter.  You are not in violation of the wash sale rule because you’re buying a different investment and at the same time accomplishing your goal of always maintaining a balanced and diversified portfolio.

As a side note, it is important to remember that our tax laws are very complex and they’re constantly changing.  Therefore, it is important to keep in mind that if you have tax questions, it pays to talk with someone who is a professional and who is dedicated to staying current about taxes.  In addition, there is a major difference between a tax preparer and a tax professional.  A tax preparer doesn’t necessarily understand the tax laws; rather, they know how to prepare a tax return.  That is something totally different than understanding our tax laws.

Good luck!