During the pandemic, a new wave of people began their trading and investing careers.

More than 10 million new brokerage accounts were opened in 2020 — a record. It’s estimated that about 27% of those were on the popular trading app Robinhood. As we rolled into 2021, this platform fueled much of the action in “meme stocks” such as GameStop (NYSE: GME) and AMC Entertainment Holdings (NYSE: AMC).

As you’re probably aware, many of these new traders were speculating. Some dabbled in risky options bets on a near-daily basis. It was fascinating and entertaining to watch all these new traders upset Wall Street. But for some traders, it’s also provided a mighty lesson in taxes.

Most of us aren’t engaging in this kind of risky behavior. But you’d do wise to remember this if you do any short-term trading.

Here’s what I mean…

A Massive Tax Bill

I first came across this insane story over at Morningstar, which first reported this story. It’s worth reading in full for those who are interested.

It told the story of just one of the millions of people who opened a new brokerage account during the pandemic. In this case, a trader plopped $30,000 into his new Robinhood account.

Robinhood, controversially, makes it easy for newbies to quickly trade options and use margin. Some say it “gamifies” investing without fully explaining the risks to novice traders.

But this new trader took full advantage and quickly scaled his trading activities. Soon, he racked up between $200,000 and $2 million in trading volume per day, completing between 10 and 50 trades daily.

He finished 2020 with transactions totaling an eye-popping $45 million. He made a net profit of $45,000 by year-end. But when he received his 1099-B tax form and input it into Turbo Tax, something shocking happened. It showed he had $1.4 million in capital gain income and a tax bill of just over $800,000.

How on earth could this happen? Simple: The wash sale rule.

What Is A Wash Sale?

Now, I should note, if you invest the way we do over at Capital Wealth Letter, you will likely never run afoul of this. So it’s not a big concern. That’s because we are investing in companies with a longer time horizon as opposed to trading ticker symbols. But if you’re one of the many investors who also keep a separate account for trading opportunities, then you should be aware of the rule…

A wash sale is when you sell a security at a loss, then buy it or a similar security 30 days after you sell it.

To comply with this Internal Revenue Service (IRS) regulation, investors must wait at least 31 days before repurchasing the same investment to avoid a wash sale.

If you’re asking why it even matters, it’s because the wash sale rule means you can’t take a tax deduction on that loss. Perhaps the only perk that comes with an investment on which you lose money is that you can deduct those losses on your taxes to offset other gains. In other words, the wash sale rule is there to stop people from using wash sales to increase tax benefits.

Here’s an example, quoted directly from the IRS:

You buy 100 shares of X stock for $1,000. You sell these shares for $750 and within 30 days from the sale you buy 100 shares of the same stock for $800. Because you bought substantially identical stock, you cannot deduct your loss of $250 on the sale. However, you add the disallowed loss of $250 to the cost of the new stock, $800, to obtain your basis in the new stock, which is $1,050.

In this specific case, this trader entered and exited his trades in the same or similar stocks so quickly that any losses he had didn’t count against his profits because he didn’t wait the 30 days.

To make matters worse, short-term gains (investments held under one year) are taxed as ordinary income. This is often higher than the long-term capital gains tax rate, which is 0%, 15%, or 20% depending on your taxable income and filing status.

For example, if you make between $44,625 and $492,300 then the long-term capital gains tax rate is just 15%. Anything under that, the tax rate is 0%, and over the $492k mark it’s 20%. Meanwhile, the ordinary tax rate for a single filer making more than $44,725 is 22%. It goes up from there, topping out at 37%.

Closing Thoughts

Like I mentioned earlier, this is one of those things that most people never had to worry about. But it is easier than ever to open a brokerage account and quickly trade in and out of stocks. So it would behoove investors and traders to learn about the wash sale rule. Nobody wants to get smacked with a hefty tax bill at the end of the year.

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