How often do you buy and sell financial instruments?
With the increase in popularity of various investments over the past few years, more and more people are investing in new markets. Whether that’s buying the hottest NFT, or dipping your toes into the crypto markets, trading is on the rise.
Those new investors are exciting - it’s fantastic to see people take control over their financial future.
But, the lack of good education also means it's quite easy to make some potentially very costly mistakes.
One important consideration for frequent traders lies in superficial losses.
What is a Superficial Loss?
A superficial loss occurs when you sell an asset at a loss, and shortly thereafter purchase a very similar (or the same) asset. If that replacement asset is purchased within 30 days, the capital loss incurred on the original sale is disallowed from a tax perspective. This means you could lose money, and still have to pay additional taxes on it.
This is especially prevalent on day-trading volatile securities.
For example, let’s say you got caught up in the Dogecoin mania earlier in the year. With the valuations bouncing +/- 10% or more in a day, placing the right bets could have made you a lot of money.
But through those trades, if you incurred a loss as prices declined, only to buy back in, those capital losses would be disallowed. While this might seem unfair, preventing you from netting your capital gains and losses against each other, there’s a good reason for this. The tax agencies created rules like the superficial loss rule to stop tax evasion schemes.
But it’s not all bad news. If you are regularly buying and selling the same asset, you lose out on the capital loss, but your cost basis for capital gains is reduced. Essentially, the loss that you incurred is added to the cost of your investment, thereby reducing the eventual capital gain (or increasing the eventual capital loss). This cost adjustment is called the “adjusted cost basis.”
Adjusted Cost Basis
To illustrate this point, consider the following example:
On September 1st, you sell your shares in ABC Co. for $20. The shares originally cost you $22. This leaves you a capital loss of $2 / share.
Then, on September 15th you purchase shares in the same company ABC Co. for $15 / share.
Because the sale and then repurchasing of the same asset occurred within 30 days, the original capital loss is disallowed. Instead, the tax calculations transfer that loss of $2/share to the new purchase price. What this looks like is the $15 in actual cost per share from September 15th, plus the $2 / share superficial loss. Therefore, on September 15th, from a tax standpoint the adjusted cost basis of each share in ABC Co. is $17 ($15 actual cost + $2 superficial loss).
If you eventually sell those same shares for a profit, the amount of taxes you pay on those capital gains is reduced by the amount of the superficial loss.
Superficial losses can increase the complexity of tax filings by a significant amount. If you are actively engaged in buying and selling frequently (Day-trading), it might be advisable to seek professional help for your tax filing.
Everyone should be investing in their financial future, but getting tripped up over a tax code violation would certainly put a damper on those good plans. The right knowledge, and an eager spirit will set you safely on the path of controlling your own financial future.