What us a disallowed wash sale?

A disallowed wash sale is a transaction that violates the IRS's wash sale rule, which prohibits investors from claiming a loss on the sale of a security if they subsequently buy a substantially identical security within a 30-day period before or after the sale. The rule is designed to prevent investors from using capital losses to manipulate their tax liabilities. When a wash sale occurs, the loss incurred on the sale of the original security is disallowed as a deduction on the current-year tax return. Instead, the loss is added to the cost basis of the replacement security, effectively deferring the recognition of the loss until the security is eventually sold or disposed of. This means that if and when the replacement security is sold, the loss will be realized and deductible to the extent that the sale results in a taxable gain. For example, consider the following scenario: 1. An investor buys 100 shares of XYZ stock for $10 per share ($1,000 of stock). 2. One year later, the stock starts dropping, and the investor sells the 100 shares for $8 per share, realizing a $200 loss. 3. Three weeks later, XYZ is trading at $6 per share, and the investor decides to repurchase the 100 shares for $600. In this case, the $200 loss from the initial sale is disallowed as a deduction on the current-year tax return. Instead, the loss is added to the cost basis of the repurchased stock, increasing the cost basis to $800. If the investor later sells the stock for $1,000, the taxable gain would be $200 instead of $400. Disallowed wash sales can occur unintentionally, such as when reinvesting dividends or exercising options, but they can also be a strategic move to defer taxes or manipulate tax outcomes. The IRS rules governing wash sales are intended to prevent such manipulations and ensure that losses are recognized and reported accurately on tax returns.