What it means
Tax systems normally allow a business or investor to deduct genuine losses against profit. But if losses could be created at will, for example by selling an asset to a friend and buying it back, the tax authority would lose revenue without any real economic change.
Disallowance rules are the safeguard. One familiar example is the wash sale rule.
If an investor sells a security at a loss and buys the same or a substantially identical one within a short window around the sale, the loss is typically denied for current purposes and added to the cost of the new holding. The investor keeps the benefit later, but not immediately.
Another example applies to sales between related parties, such as family members or companies under common control. Because the asset stays within the same economic group, the loss is often disallowed until the asset is sold to an outsider, since nothing has really left the family or group.
Related rules in some countries also address losses on shares of subsidiaries within a group of companies. The detail of each rule, including the length of the time window, the definition of related parties and the way a denied loss is deferred or lost, varies by country and can change.
This entry therefore explains the principle rather than any specific current rate or period. For businesses, the practical point is to check the tax effect of a planned sale before executing it.
A transaction that looks sensible commercially may produce no deduction, and the denied loss can affect forecasts, covenants and the timing of cash tax savings. Companies should also think about the financial reporting side.
When a loss may be disallowed, the related deferred tax asset (a future tax saving recorded on the balance sheet) is only recognised if it is likely to be used. Auditors will ask for support, and an optimistic assumption can lead to a restatement.
In practice
Real-world examples.
Example
An investor sells shares at a $12,000 loss in December to reduce her tax bill and buys them back two weeks later. Under a wash sale rule the $12,000 loss is disallowed for now and added to the cost of the new shares. When she eventually sells the replacement shares for good, the deferred loss will reduce her taxable gain at that point.
Example
A founder sells a rental property at a loss to a company he controls. Because the buyer is a related party, the tax authority disallows the deduction until the company sells the property to an outsider.
Example
A corporate group sells shares in one of its subsidiaries to another group company at a loss. The tax adviser explains that internal sales within the group may not generate a deductible loss, so the plan is dropped. The group instead considers a genuine sale to an independent buyer, which will take longer but is far more likely to withstand scrutiny.
Case study
Seen in the real world.
Harlow & Finch Trading is an illustrative, fictional company whose owner held an investment property that had fallen in value by $200,000. Late in the tax year, he proposed selling it to his sister's company, planning to claim the loss against the group's profits.
His accountant explained that sales between related parties were covered by a loss disallowance rule. The $200,000 deduction would be denied, and could be used only if the buyer later sold the property to an unrelated party at a price that realised the gain or loss.
The owner chose instead to hold the property until a genuine sale to an outside buyer. In this illustrative story the delay cost him a year of tax relief, but he avoided a disallowed deduction and a possible penalty for aggressive planning. He also documented the commercial reasons for each later transaction, which is good practice whenever related parties are involved.
Watch out
Common mistakes.
- Assuming a sale automatically creates a deductible loss, when rules about related parties and repurchases may deny it.
- Believing a disallowed loss disappears forever, when in many rules it is deferred and added to the cost of the replacement asset.
- Relying on a rule of thumb about time windows without checking current law, which changes between countries and over time.
Questions
People also ask.
Why do tax authorities have these rules?
To stop taxpayers from creating tax losses through transactions that change nothing in economic substance.
Does a disallowed loss ever get used?
Often yes, because many rules postpone rather than cancel the deduction, which becomes available when the asset is eventually sold to an unrelated buyer.
Who should check these rules?
A qualified tax adviser, before the trade is made, since the rules are technical and the details vary by jurisdiction.
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