The market has been volatile in 2021 so far, and it's no different for recent tech IPOs. If you exercised ISOs when the price was higher than it is now (or it’s a situation you could find yourself in), be wary of an obscure situation that could lead to a big tax surprise: the wash sale.
In essence, a wash sale occurs when you buy back stock within 30 days (before and after) of selling it at a loss. The IRS doesn't allow the loss from wash sales to be recognized, so you won't be able to use the sale to offset other capital gains. It’s usually pretty easy to see a wash sale coming: if you lost money in a sale and are going to report a capital loss on your tax return, don’t buy the stock back within 30 days or you’ll trigger a wash sale. But it's a little trickier for stock acquired by exercising ISOs.
What is it about ISOs that can lure unsuspecting shareholders into a wash sale trap? It’s a special rule when it comes to disqualifying dispositions, the relative ease of acquiring additional shares if you’re still at the company, and an unintuitive definition of “loss”. Combined, these factors can lead to unintentional and devastating tax consequences.
Note that the ISO wash sale trap is relevant only if you’re making a disqualifying disposition. The wash sale rule still applies for qualifying dispositions but it's easier to spot and avoid.
The Special Rule:
If you make a disqualifying disposition of ISO stock that would result in a loss being recognized (if sustained), the income includible from a disqualifying disposition of ISO stock is limited to the sale amount less your cost to exercise.
(The full text, written in headache-inducing alien tax language, can be found in Title 26 of the Code of Federal Regulations, § 1.422-1(b)(2).)
You might hear that a disqualifying disposition of ISO stock effectively turns them into NSO stock, but that's not quite true. Take this situation: an exercise price of $100, a price when you exercise of $400, and a sale price of $300.
With NSOs, the entire exercise spread ($400 - $100 = $300) is includible in gross income and you pay ordinary income taxes on that spread. Your cost basis is reset to $400, and when you sell at $300, you have a capital loss of $100 which you can use to offset capital gains and a limited amount of ordinary income.
This special rule dictates that for a disqualifying disposition of ISOs, the amount includible in your income is limited to the $300 sale price less the $100 exercise price, or $200. Your income is limited to the gain over your exercise price, and there's no capital loss.
The difference between the two is significant because of the way capital losses offset capital gains and ordinary income, but this is outside of the scope of the wash sale trap.
A Limitation to the Special Rule:
The special rule for ISOs doesn't apply if the loss (if sustained) from the disqualifying disposition would NOT be recognized. For example, if a wash sale occurs.
A wash sale negates the special rule, so you'd have to pay ordinary income taxes on the entire exercise spread (just like for NSOs), not the lower sale minus exercise amount. You'd normally be able to report a capital loss, but due to the wash sale rule, you can't recognize a capital loss to offset other gains and ordinary income. And to add insult to injury, the new shares you bought won't retain the ISO characteristics of the ISO stock you initially sold, so you're very likely to have permanently lost any benefits of having ISO stock. By falling into this trap, you end up worse off than if you had just held onto the stock.
Notice that in the ISO sale example above, a loss never actually occurred. When the special rule limited income recognition to ordinary income of $200 (the $300 sale price less the $100 exercise price) and no capital loss was generated, a profit was realized instead. The phrase “if sustained” and the circular logic of the special rule means a situation like this would open the door to a potential wash sale and trigger the limitation to the special rule – even though there is no loss!
I’ll just be careful to not buy my stock back within 30 days. I’m good, right?
You’re halfway there. Not placing buy orders in your brokerage account is important. But if you forget about the rest, you’re livin’ on a prayer.
It’s not hard to accidentally trigger a wash sale without realizing it. Exercising NSOs or ISOs, vesting into RSUs, or unlucky timing with an automatic ESPP purchase can all trigger wash sales. And if you like holding some company stock in your 401k or IRA, be careful about your purchases there too.
If you're in a similar situation and want to sell your ISOs in a disqualifying disposition, here's what you need to do to avoid triggering a wash sale:
Map out every relevant date related to your equity compensation. You should already be aware of these dates and know where to access them, but here you need to put together a clear timeline. When do your RSUs vest, when does your company purchase stock for its ESPP, do you have trading windows and other timing restrictions, when do your NSOs and ISOs expire, do you need to exercise options for any other reason by a certain day, etc. Without answers to these questions, you’re making a big gamble that you won’t accidentally acquire stock during a wash sale window.
Coordinating with your stock compensation and benefits liaisons can be helpful, and working with an accountant and financial advisor knowledgeable around stock compensation can prevent timing blunders and direct an action plan. There’s really not much else to do except to exercise caution when dealing with a disqualifying disposition of ISO stock that falls under the special rule. Knowing that this convoluted and obscure rule exists and how to avoid the trap is the key. Feel free to send me an email or schedule a time to talk if you'd like to know if the ISO wash sale trap could apply in your situation.