Why It’s Important to Understand the Wash Sale Rule

Most investors are familiar with the “wash sale” rule – but that doesn’t stop them from trying to find ways around it, especially in today’s market environment.

A wash sale occurs when you sell a security at a loss, then buy back the same security (or what the Internal Revenue Service calls something “substantially identical”) within 30 days. The idea is to take a capital loss and keep the security – in essence, to have your cake and eat it too. Clearly, the IRS frowns upon this.

Some people trying to find a way around the wash sale rule mistakenly assume it refers only to buying back a security 30 days after the sale – but it applies before a sale as well.

What does that mean? To illustrate, let’s say you buy a stock and hold it for several years. You then purchase additional shares and sell the initial shares at a loss a few days later. You then deduct the loss.

That seems like it would work – but it doesn’t, because the wash sale rule still applies. You can’t sell a security then buy the same security 30 days before or after the sale.

Some areas of the law are fuzzy, as is the case with many IRS regulations. For example, the definition of “substantially identical” is unclear. And the wash sale rule can get confusing when used with derivatives, which are sophisticated securities that derive their value from the value of underlying securities.
As a result, you may want to consult your financial advisor before buying and selling any security

Ways to Find Companies That Won’t Cut Dividends

For many investors, one of the most challenging aspects of a recession is the decline in dividends that often accompanies it.

First, let’s review dividends. When a company earns profits, it often pays a share of those profits to its shareholders (directly or through mutual funds). These profits are called dividends. Typically, dividends are paid by well-established companies that generate regular profits but are too mature to grow significantly.

In a recession, many companies cut or suspend their dividends, and we see that happening now. According to Standard & Poor’s, a record number of companies cut their dividends in the first quarter of 2009. As a result, dividend decreases outpaced increases for the first time since S&P started tracking dividends in 1955 – resulting in a net dividend decrease of $77 billion.

How can you predict whether a company will cut dividends?

The size of the company. Many of the earliest dividend cuts were made by large companies. Although smaller companies could be next, the unfavorable investor sentiment resulting from cuts by larger companies could inspire smaller ones to prevent cuts.

The type of stock. Dividend cuts on preferred shares, which are hybrid securities that resemble both stocks and bonds, are rarer than dividend cuts on common shares.

A history of raising dividends. By regularly committing to distributing more of its earnings to shareholders, a company may be signaling that its prospects are good.

Where companies get the money to pay their dividends.
Many financial advisors like to see dividends supported by current earnings rather than a company’s nest egg of cash and marketable securities.

Of course, you may not be comfortable poring over a company’s books and researching its history. In this case, you can always help protect yourself from a dividend cut via two standbys: consult your financial advisor, and maintain a diversified portfolio.