Investors cannot claim a tax loss on the sale of a security if they buy a “substantially identical” security within 30 days before or after the sale, as per the wash-sale rule, a tax regulation.

The Internal Revenue Service (IRS) in the United States established the wash-sale rule, which restricts investors from deducting a tax loss from their taxes if they sell an investment at a loss and subsequently buy a virtually identical security within the 30-day window. Instead, they must factor the loss into the new security’s cost base, which will reduce their gain or raise their loss when they ultimately sell the new asset.

Cost basis refers to the original value of an asset, such as a stock or a cryptocurrency, that is used to determine the taxable gain or loss when the asset is sold or disposed of. The cost basis is typically the purchase price of the asset, including any fees or commissions associated with the purchase. The cost basis may be changed to reflect the asset’s fair market value at the time of acquisition if the asset was received as a gift or through inheritance.

When an asset is sold, the capital gain or loss is determined using the cost basis. The investor obtains a capital gain and may be subject to taxation on that gain if the asset’s sale price exceeds its cost basis. The investor experiences a capital loss if the sale price is less than the cost basis. This loss can be used to offset capital gains and minimize the investor’s tax burden.

“Substantially identical” refers to securities that are almost identical to the security sold, as in the case of purchasing a stock, selling it, and purchasing the original stock back within 30 days. However, it can be difficult to determine what constitutes a substantially identical security, and the IRS has broad discretion in making this determination.

The wash-sale rule was created to stop investors from claiming tax deductions for losses while maintaining their portfolio’s original structure. All forms of securities, such as stocks, bonds, mutual funds and options, are covered by this rule.

For instance, the wash-sale rule would likely apply, and the investor would not be able to claim the tax loss on the sale if the investor sold shares of a certain company at a loss and then purchased shares of the same company or a company that is similar in the same industrial sector within 30 days. In a similar vein, if an investor sells shares in a mutual fund that tracks the S&P 500 index and then purchases shares of a different mutual fund that tracks the same index within 30 days, the investor is subject to a 30-day penalty.

Related: How are metaverse assets taxed?