What Is a Disallowed Loss? Causes, Reporting, and Penalties

A disallowed loss is a loss on the sale or disposal of property that the tax code specifically prohibits you from deducting, even though you genuinely lost money. The Internal Revenue Code steps in and blocks the deduction in four main situations: sales between related parties, wash sales of stock or securities, losses from activities the IRS treats as hobbies rather than businesses, and losses on property you used personally. Some of these losses attach themselves to replacement or transferred property and produce a tax benefit later. Others simply vanish.

How a Loss Becomes Disallowed

You realize a loss whenever you sell or dispose of property for less than your adjusted basis, which is generally what you paid plus improvements, minus any depreciation you claimed.¹ If the property was held for business or investment, that loss is usually deductible. A specific anti-abuse rule has to apply before the code takes the deduction away.

Keep one distinction clear from the start. A disallowed loss is not the same as a suspended or limited loss. Passive activity losses that exceed your passive income are suspended and carried forward until you have enough passive income to absorb them or you sell the entire interest to an unrelated buyer.² Losses limited by the at-risk rules under Section 465 are capped at the amount you have personally at risk and roll forward until your at-risk amount grows.³ Those losses will eventually be deducted. A truly disallowed loss is either permanently gone or transferred to someone else’s basis.

Sales Between Related Parties

If you sell property at a loss to a related party, the deduction is disallowed regardless of whether the price was fair.⁴ The reasoning: when property stays inside the same economic family or business group, the loss lacks real finality.

Who Counts as a Related Party

The definition catches more people than most expect. Section 267 lists 13 categories of related-party relationships. The ones that reach individual taxpayers most often are:

Family members, meaning siblings, spouses, ancestors (parents, grandparents), and lineal descendants (children, grandchildren). Aunts, uncles, cousins, and in-laws are not on the list.
You and a corporation, if you own more than 50% of its stock directly or indirectly.
A trust and its grantor, fiduciary, or beneficiary in several combinations.
Commonly controlled businesses, such as two corporations in the same controlled group, or a corporation and a partnership with more than 50% overlapping ownership.
An estate’s executor and a beneficiary, except for sales that satisfy a specific cash bequest.

Ownership is not limited to shares in your own name. Constructive ownership rules attribute stock held by your family members and certain entities to you for the 50% test.⁵ If your spouse owns 30% of a corporation and you own 25%, you are treated as owning 55%.

What Happens to the Loss

The seller loses the deduction, but the loss is not entirely wasted. If the related buyer later sells the same property to an unrelated person at a gain, the buyer’s taxable gain is reduced by the amount of the previously disallowed loss.⁴ The benefit is capped at that gain. If the buyer sells at a loss, or at a gain smaller than the original disallowed loss, the unused portion is gone.

Say you sell land to your daughter at a $10,000 loss. Your loss is disallowed. She later sells to a stranger for a $4,000 gain. Her taxable gain becomes zero because the $10,000 disallowed loss more than covers it, but the remaining $6,000 benefits no one.

The Wash Sale Rule

The wash sale rule stops you from claiming a loss on a security while keeping the same economic position. If you sell stock or securities at a loss and buy substantially identical stock or securities within a 61-day window (30 days before through 30 days after the sale), the loss is disallowed.⁶ The rule reaches purchases, exchanges, and even contracts or options to acquire the same security.

Unlike a related-party loss, a wash sale loss is not gone. It is added to the cost basis of the replacement shares, which reduces your eventual gain or increases your eventual loss by the same amount.⁶ The holding period of the original shares also carries over. The tax benefit is deferred, not destroyed.

A simple example. You bought 100 shares at $10 each for $1,000, sold them for $600, and bought 100 shares of the same stock back a week later for $600. Your $400 loss is disallowed. The basis of the new shares becomes $1,000 ($600 purchase price plus the $400 disallowed loss). When you eventually sell those replacement shares, the $400 comes back into the calculation.

What “Substantially Identical” Means

The IRS has never published a bright-line definition. It is a facts-and-circumstances test. Shares of the same company are substantially identical. Shares of two different companies generally are not, even in the same industry. Bonds or preferred stock of a company are ordinarily not treated as substantially identical to that company’s common stock. For mutual funds, shares of one fund are generally not substantially identical to shares of a different fund, even when both track similar indexes. This is the space that tax-loss harvesting strategies use, such as selling one S&P 500 index fund at a loss and buying a different provider’s S&P 500 fund. The IRS has not explicitly blessed the approach, but the general guidance suggests different funds are not substantially identical.

Cryptocurrency

As of 2026, the wash sale rule applies only to stock and securities. Cryptocurrency is classified as property for federal tax purposes, not as a security, so the wash sale rule does not currently reach crypto trades. You could sell Bitcoin at a loss and buy it back the next day without triggering a wash sale. Congress has proposed extending wash sale treatment to digital assets in several bills, but none have been enacted. Watch for legislative changes if you trade crypto actively.

Hobby Losses

If the IRS treats an activity as a hobby rather than a legitimate business, you cannot deduct any net loss from it. The test under Section 183 turns on whether you genuinely intend to make a profit.⁷

There is a statutory safe harbor. If your activity produces a net profit in at least three of the last five tax years (two of seven for horse breeding, training, showing, or racing), the IRS presumes a profit motive.⁷ Fall short and the IRS may weigh nine factors, including how you run the operation (books, business plan, businesslike conduct), your expertise, the time you devote, the history of income and losses, whether occasional profits are meaningful compared to the losses, whether you have substantial other income the losses conveniently offset, and whether the activity is inherently recreational. No single factor decides the question, but auditors focus hardest on the first: sloppy records and no business plan make every other factor harder to win.

The sting goes beyond losing the loss. Under the Tax Cuts and Jobs Act, miscellaneous itemized deductions subject to the 2% floor were suspended starting in 2018. The One Big Beautiful Bill Act (Pub. L. 119-21) made that suspension permanent, so hobby-related expenses like supplies, entry fees, and travel can no longer offset hobby income at all.⁸ Hobby income is still fully taxable. You pay tax on every dollar of revenue and deduct nothing against it.

Personal-Use Property

The code limits individual loss deductions to three categories: losses from a trade or business, losses from transactions entered into for profit, and certain casualty or theft losses.⁹ Personal-use property such as your home, your car, your furniture, and your jewelry falls outside all three. If you sell a personal item for less than you paid, the loss is not deductible.¹⁰

The asymmetry frustrates many taxpayers. Gains on personal-use property are taxable as capital gains, but losses are not deductible. Sell a collectible at a profit and you owe tax; sell your car at a loss and you get nothing. The one major exception is the primary residence exclusion, which lets you exclude up to $250,000 of gain ($500,000 if married filing jointly) when you sell your main home, provided you meet the ownership and use requirements.¹¹

If you convert personal property to business or income-producing use, such as turning your former home into a rental, you may be able to deduct a later loss on sale. The basis rules are designed to keep the pre-conversion decline in value out of the deduction: your depreciable basis starts at the lower of adjusted cost basis or fair market value on the date of conversion. Any drop in value that happened while the property was still personal is not deductible.

How to Report a Disallowed Loss

You still have to report the transaction, even though you cannot deduct the loss. Most disallowed losses run through Form 8949 and feed into Schedule D.¹²

For a wash sale, report the transaction on Form 8949, enter code W in column (f), and put the disallowed loss as a positive number in column (g). The adjustment zeroes out the loss on that line.
For losses disallowed for other reasons, such as a related-party sale or a personal-use property loss, use code L in column (f) and enter the nondeductible amount as a positive adjustment in column (g).

Getting this right matters. If you leave the transaction off entirely, the IRS may not see that you tracked the disallowance, and the basis adjustment on replacement shares or the transferred loss benefit on related-party property becomes harder to prove later.

Penalties for Claiming a Disallowed Loss Anyway

Deducting a loss the code does not allow creates a tax underpayment, and the IRS can impose an accuracy-related penalty of 20% of the resulting underpayment.¹³ The penalty applies to underpayments caused by negligence, substantial understatement of income tax, or disregard of rules and regulations. Negligence, in the IRS’s view, includes any failure to make a reasonable attempt to follow the law.

The penalty doubles to 40% when the underpayment results from an undisclosed transaction lacking economic substance.¹³ A sham sale to a related party structured purely to harvest a tax loss is exactly the kind of arrangement that triggers the higher rate. Interest on the underpayment accrues on top of the penalty from the return’s original due date.

If you are unsure whether a loss qualifies, the cost of getting it wrong is the lost deduction plus 20% to 40% of the tax you should have paid, plus interest. That math almost always favors checking with a tax professional before filing, not after the IRS notices.

1
Office of the Law Revision Counsel. 26 USC 1001 – Determination of Amount of and Recognition of Gain or Loss
2
Internal Revenue Service. Topic No. 425, Passive Activities – Losses and Credits
3
Office of the Law Revision Counsel. 26 USC 465 – Deductions Limited to Amount at Risk
4
Office of the Law Revision Counsel. 26 USC 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers
5
eCFR. 26 CFR 1.267(c)-1 – Constructive Ownership of Stock
6
Office of the Law Revision Counsel. 26 USC 1091 – Loss From Wash Sales of Stock or Securities
7
IRS.gov. Is Your Hobby a For-Profit Endeavor?
8
Office of the Law Revision Counsel. 26 USC 67 – 2-Percent Floor on Miscellaneous Itemized Deductions
9
Office of the Law Revision Counsel. 26 USC 165 – Losses
10
Internal Revenue Service. Publication 544 (2025), Sales and Other Dispositions of Assets
11
Office of the Law Revision Counsel. 26 USC 121 – Exclusion of Gain From Sale of Principal Residence
12
IRS. Instructions for Form 8949
13
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments