Overview
On October 28, 2021, the House Rules Committee released the latest version of HR 5376, the Build Back Better Act. This draft reflects the most recent attempt to forge compromise among Democratic lawmakers, as Congress moves towards a vote on a comprehensive infrastructure bill. Section 138152 of the Build Back Better Act (the Act) would amend Internal Revenue Code (Code) section 1091, which currently disallows losses for so-called "wash sales" of "stock or securities" (or contracts or options to acquire or sell stock or securities), to apply to a wider range of investment assets and to apply to acquisitions of substantially identical assets by related parties.
Current Statute. Currently, Code section 1091 does not permit a taxpayer to claim a deduction under Code section 165 for a loss from the sale of shares of stock or securities where it appears that the taxpayer acquired or entered into a contract or option to acquire substantially identical stock or securities. A similar rule applies to short sales and securities futures contracts.
The loss is not disallowed forever, but rather deferred. This is accomplished by an increase in the basis of the stock or securities acquired by the amount of the loss deduction denied.
This wash sale rule is intended to prevent loss harvesting if the investor is really just continuing the investment. As such, it does not apply if the taxpayer is a dealer in stock or securities and the loss is sustained in a transaction made in the ordinary course of such business.
Build Back Better Act Amendments
Under the Act, if adopted, the wash sale provisions would apply to a much broader range of assets, including foreign currency, commodities, and digital assets. Specifically, the wash sale provisions would apply to the following assets:
- Stocks and securities – Although the current statute applies to wash sales of stock and securities, the Act would adopt an express definition of stock and securities by cross-referencing Code section 475(c)(2) (relating to mark-to-market accounting for dealers in securities):
- any stock in a corporation;
- any partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust;
- any note, bond, debenture, or other evidence of indebtedness;
- any interest rate, currency, or equity notional principal contract;
- any interest, or derivative financial instrument, in any security described above, or any currency, including any option, forward contract, short position, and any similar financial instrument in such a security or currency;
- foreign currency;
- commodities described in Code section 475(e)(2):
- any "actively traded" commodity (within the meaning of Code section 1092(d)(1));
- any notional principal contract with respect to an "actively traded" commodity;
- any interest, or derivative instrument, in any commodity described above, including any option, forward contract, futures contract, short position, and any similar instrument in such a commodity; and
- except as otherwise provided by the Secretary of the Department of the Treasury, any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the treasury secretary.
In addition, the Act makes clear that the law would apply to a contract or option to acquire or sell specified assets even if the contract or option settles in (or could be settled in) cash or property other than such specified assets.
The Act would apply to acquisitions of substantially identical assets not only by a taxpayer, but also by a "related party." For this purpose, related party includes a spouse, dependent, a corporation, partnership, trust, or estate which controls, or is controlled (defined using a 50% threshold) by the taxpayer, and certain types of accounts (including IRAs, health savings accounts, section 529 accounts, Coverdell education savings accounts, and qualified retirement plan accounts) if the taxpayer has the right to make any investment decision with respect to such account.
Significantly, with respect to acquisitions of substantially identical assets by related parties, the Act would not permit a basis adjustment (except for acquisitions by spouses). That means that the loss is disallowed forever. As a result, taxpayers will have to closely monitor activity by related parties—for example, activities by dependents on other trading platforms.
The Act includes a carveout for certain business transactions. The disallowance of loss deductions would not apply for either foreign currency or commodity transactions that are (i) directly related to the business needs of a trade or business of the taxpayer (other than the trade or business of trading) or (ii) that are part of a hedging transaction (as defined in Code section 1221(b)(2)). The carveout provision does not apply to digital asset transactions.
Impact
While the Code currently has a wash sale loss disallowance provision for stock and securities transactions, passage of this legislation would be a significant development that could affect the entire financial services industry, including proprietary trading, speculative transactions, personal investment activity, and digital currency trading activity. While the hedging carveout might mitigate the blunt nature of the Act, this provision, if enacted, could have significant repercussions for institutional and retail currency and commodity market participants, as this could cause fundamental changes in longstanding investment and trading practices.
Wash sales could be particularly difficult to track in the context of digital assets. There are a few cryptocurrencies (e.g., BTC and ETH) that are used to access many other protocols. For example, to access a DeFi protocol, a user might convert ETH to the crypto native to the DeFi platform. That means that a user would buy and sell these "gateway" cryptocurrencies much more frequently than others, potentially triggering the wash sale rule. These do not appear to be the types of continuing investment transactions at which the wash sale rules were targeted.
