The Wash Sale Rule Explained

Under IRC Section 1091, you can’t claim a tax loss on a security if you buy a “substantially identical” replacement within 30 days before or after the sale. The full window spans 61 days. If you violate it, the loss gets disallowed for that tax year and instead gets added to your cost basis in the replacement shares.

Simple example: you bought 100 shares of a tech stock at $150/share. It drops to $100. You sell for a $5,000 loss on December 10. On December 28, you buy the same stock back. The $5,000 loss is disallowed, and your new shares have a cost basis of $105 per share ($100 purchase price + $50/share disallowed loss).

California’s No Preferential Rate Problem

The federal tax code taxes long-term capital gains at 0%, 15%, or 20% depending on your income bracket. California doesn’t do that. All capital gains — short-term and long-term — get taxed at the same rates as ordinary income, topping out at 13.3% (including the 1% Mental Health Services Tax on income over $1 million).

For an LA investor, here’s what a $10,000 capital loss is worth in tax savings at the top brackets:

• Federal (long-term gains): $2,000 at the 20% rate
• Federal NIIT: $380 at 3.8%
• California: $1,330 at the 13.3% rate
• Total: $3,710 per $10,000 in long-term losses harvested

For short-term gains, the federal rate jumps to 37%, making the total savings up to $5,410 per $10,000. A wash sale that disallows these losses hits California investors particularly hard because the state offers no relief or separate calculation.

Tax-Loss Harvesting Strategies for LA Investors

Given California’s tax burden, LA-based investors should harvest losses proactively throughout the year rather than waiting for December. Here’s a disciplined approach:

• Set loss thresholds: Flag any position down 10% or more for potential harvesting. With California’s 13.3% rate, even small losses generate meaningful tax savings.
• Swap, don’t sell and sit: Replace the sold position immediately with a similar (but not substantially identical) fund. Sell the Vanguard Total Stock Market ETF (VTI) and buy the iShares Core S&P Total U.S. Stock Market ETF (ITOT). Different fund, similar exposure.
• Watch for year-end distributions: Mutual funds distribute capital gains in December. Harvesting losses before those distributions hit can offset the tax impact.
• Track across accounts: California conforms to federal rules, so the wash sale applies across all your accounts — taxable, IRA, your spouse’s accounts if filing jointly. Coordinate carefully. See IRS Publication 550 for cross-account rules.

California Conformity and Reporting

California fully conforms to the federal wash sale rule. Your federal adjusted gross income, which reflects wash sale adjustments reported on Form 8949 and Schedule D, flows directly to your California Form 540. There’s no separate California wash sale calculation or exception.

Brokers report wash sales on Form 1099-B with a code “W” in Box 1f. The disallowed loss amount appears in Box 1g. If your broker doesn’t track wash sales across different accounts (most don’t), you’re responsible for identifying and reporting cross-account wash sales yourself.

One California-specific consideration: the Franchise Tax Board (FTB) has been increasingly aggressive about matching 1099-B data. If you fail to report a wash sale adjustment that your broker reported to the IRS and FTB, expect a notice.

The $3,000 Deduction and Carry-Forward

Net capital losses exceeding your capital gains can offset up to $3,000 of ordinary income per year under IRC § 1211 ($1,500 if married filing separately). The rest carries forward indefinitely. California follows the same $3,000/$1,500 limit.

For a high-income LA investor, that $3,000 deduction against ordinary income saves roughly $1,600 in combined federal and California taxes. Not life-changing in a single year, but carry-forward losses accumulated over volatile markets can provide years of tax benefits.

Sources & References

• 26 U.S.C. § 1091 — Loss from Wash Sales of Stock or Securities
• IRS Publication 550 — Investment Income and Expenses
• CA Franchise Tax Board — Tax Rates and Tables
• CA FTB — Mental Health Services Tax (1% Surcharge)
• IRS — Net Investment Income Tax (3.8% Surtax)
• 26 U.S.C. § 1211 — Limitation on Capital Losses
• IRS — Form 8949 (Sales and Dispositions of Capital Assets)
• IRS — Schedule D (Capital Gains and Losses)