Tax Loss Harvesting & the 'Wash Sale' Rule

Market action in the past couple of weeks has probably caused many investors to begin thinking about selling some securities to “harvest” losses for tax purposes.

Those who wish to maintain their market exposure and asset allocations after the sale, and still benefit from the tax losses, must comply with the “wash sale” rule. That rule requires that the investor wait 30 days before repurchasing the same security or another security that is “substantially identical”.

The meaning of “substantially identical” would be the debating point with an IRS examiner in an audit.

We interviewed Robert Willens, CPA, managing director at Lehman about the question. He was formerly tax partner-in-charge of the capital markets group at KPMG Peat Marwick and is a prolific author on tax matters.

He pointed out that “substantially identical” has never been fully defined – that it is one of those things that perhaps you can’t define, but you know it when you see it. Overall, he pointed out that the intent of Congress in legislation was to prevent investors from recreating the same economic position and risk exposure within the waiting period.

The kinds of examples given by the IRS in their information booklet, IRS Publication 550: Investment Income and Expenses, are not very helpful in the case of investment funds.

From the IRS description, you come away with the sense that you need to make sure the issuers of the securities are different to be safe. For example, you might sell General Motors (GM) at a loss and buy Ford (F) for 30 days. After 30 days, you would sell Ford and buy back General Motors. Same industry, possibly same result, but different issuers – no problem.

A reasonable extension of the logic would be that you might sell an actively managed mutual fund and replace it with another actively managed mutual fund pursuing the same nominal objective and be OK with the rule. To illustrate, in a 1998 interview with TheStreet.com, Thomas P. Ochsenschlager, CPA, then tax partner at Grant Thornton in Washington D.C, and now Vice President Taxation of the American Institute of Certified Public Accountants [AICPA], gave this example as a safe substitution “For example, sell your shares in Fidelity Growth & Income and buy Dreyfus Growth & Income instead.”

But, what if an investor wants to put a finer point on the question? We put some scenarios in front of Robert Willens and asked him to give them a tax sniff test.

Here are the scenarios we provided:

Assume that the investor owned (SPY) (S&P 500 issued by State Street Global Investors) and sells it at a loss, then immediately reinvests the full sales proceeds with one or more other securities as follows:

Scenario A:
Purchases (IVV) (iShares S&P 500) or VFINX (Vanguard S&P 500).

Scenario B:
Purchases (IVW) (iShares S&P 500 Growth) and (IVE)(iShares S&P 500 Value) in equal dollar amounts.

Scenario C:
Purchases (IWB) (iShares Russell 1000) or (IWV) (iShares Russell 3000) or (VTI) (Vanguard DJ Wilshire 5000)

Scenario D:
Purchases all 500 of the S&P 500 stocks in the same proportion that they exist in the S&P 500 index (not a likely scenario, but worth including to explore the question)

Your brokerage house or mutual fund company will not help you with these scenarios. They refer you to either your “personal tax advisor” or the IRS. The IRS will not help you, because their front line help desk is staffed with generalists who will not answer any but garden variety questions. They refer you to your “personal tax advisor” who may or may not be comfortable rendering an opinion on such a finely parsed set of examples.

That would be unfortunate, because as an investor you may wish to keep you exposure as close as permissible to your original exposure and still be on the good side of the wash sale rule.

Like your broker or mutual fund company, we must state that we are not tax advisors. Unlike them we will give you our opinion, but it counts for nothing unless confirmed by a qualified expert. We are not advising you, just exploring a question. Mr. Willens also pointed out that he is not providing any personal advice to any reader of this article, nor is Mr. Ochsenschlager whose quote was extracted from another article. You need to get advice from your “personal tax advisor”. However, you can take this article to your personal tax advisor to give them something substantial to consider when they give you advice based on your question about your transaction.

Here are Mr. Willens’ thoughts on our four scenarios:

Replacing one S&P 500 fund with another is a problem, because there is no effective change in economic position or risk exposure. Using different issuers doesn’t change the character of the investment which was the intent of the rule.

Replacing an S&P 500 index fund with all 500 individual S&P stocks according to index weights doesn’t work either for the same reason.

Replacing an S&P 500 fund with an S&P 500 Growth fund and an S&P 500 Value fund probably doesn’t work either, because the underlying portfolio of stocks is the same and the economic position of the investor has not changed.

Replacing an S&P 500 fund with a Russell 1000 fund, or a Russell 3000 fund, or a DJ Wilshire 5000 fund, probably does work, because the underlying portfolio is not the same and therefore the economic position and risk exposure are not the same.

Another issue we explored with Mr. Willens is the significance of correlated outcomes. What if the performance of the sold and purchased funds where historically very closely correlated, even though their portfolios were not the same?

He said that clearly, if you sold GM and bought Ford, it would make no difference if their price charts looked like a perfect overlay. But what if the S&P 500 chart and the Russell 1000 chart were a very close overlay? Would that invalidate the argument that a 1000 stock portfolio is not “substantially identical” to a 500 stock portfolio? What counts; the similarity of successive 30 day periods, or long-term differences in price charts?

Consider these two price charts of SPY (S&P 500) and IWB (Russell 1000) over the last 30 days (equal to the wash sale waiting period) and eight years;

[click image to enlarge]

The portfolios are different and over time the return differences become significant. In some 30 day periods the results are different, but in some they are the same. Generally, in any thirty day period they are very highly correlated. What does that mean about “substantially identical”?

According to Mr. Willens, correlation of price and returns is only a factor in determining securities to be substantially identical in cases where (a) the securities of two different companies are undergoing merger, or (b) the securities of one company are convertible into one another – that correlation of return and price movement is not a basis for two mutual funds to be determined to be “substantially identical”

Note that in the case of a hub-and-spoke structure like that used by Vanguard to issue different classes of shares with a common portfolio (such as the exchange traded fund VTI and the corresponding mutual fund VTSMX) it is not the near perfect correlation (except for expense ratio differences), but the fact that they invest in a shared portfolio that makes them “substantially identical”

With interview comments from Mr. Willens and reported comments from Mr. Ochsenschlager in mind, we thought we’d take on a scenario for ourselves. What if the investor sold SPY and immediately purchased RSP (Rydex S&P 500 equal weight)?

Let’s look first at what the two funds own by examining the top ten holdings of each and the weight each holding has in the portfolio.

[click image to enlarge]

It’s clearly obvious that these two funds do not create a similar economic position and risk exposure. All of the holdings of RSP are of essentially equal weight and all of the holdings of SPY have a uniquely determined weight. EXXON in SPY, for example, will have 14 times the weight it has in RSP, and Proctor & Gamble will have over 6 times the weight.

The rest of the two portfolios will also show significant differences in weights for holdings of their shared list of constituents.

Our understanding of the meaning of “substantially identical” is that replacing an S&P 500 fund with an equal weight S&P 500 fund is not a problem, because while the two funds have exactly the same names in the portfolio, they hold them in significantly different proportions, creating a significantly different economic position and risk exposure for the investor. Since the economic position and risk exposure are substantially different, the funds are not substantially identical.

Fund Substitution Working Rules:

Our take on all this is that the best working rules for replacing a fund during a wash sale waiting period to avoid running afoul of the rule could probably be put this way:

1) Replace one actively managed fund for another if the issuers and managers are not the same.

2) Replace one index fund for another index fund, even though there may be overlap in their holdings, if the index of the sold and of the purchased fund are not the same index, and the differences between the indices are obviously significant (e.g. either they have a significantly different number of index constituents or they hold the same constituents but in significantly different proportions).

3) Replace any index fund with any actively managed fund regardless of issuer

4) Replace any actively managed fund with any index fund regardless of issuer.

AND, as we are all wont to say, ask your “personal tax adviser” before making any tax based decision. No statement in this article is personal tax advice.

Disclosure: Author owns SPY and sometimes owns IWB, IWV or VTI

Comments

[jbmaria:]

Good article Mr. Shaw.
I think I may have screwed up inadvertently if I'm reading this right.
A client I advise had a loss in the IWM ETF. To capture the loss,I simultaneously sold the IWM and invested the money in the UWM ETF,which is a 2X leveraged play on the same underlying index,the Russell 2000.

Simple question,is it a violation of the wash rule?
Does the 2X leverage eliminate or negate the “substantially identical” caveat to the wash rule?

2008 Dec 15 03:54 PM

[QVM Group:]

jbmaria:

Cautioning that I am not a tax advisor, that you cannot rely on my comments for tax decisions (only to stimulate further tax research by you, or to help you frame questions) and that you should consult your own tax advisor, I will offer my uncertified personal view that substituting a 2X fund tracking the same index as a 1X fund you sold for a loss does not qualify under the Wash Sale Rule.

Richard Shaw

2008 Dec 15 04:49 PM

[jbmaria:]

Thanks Richard but at the risk of sounding "dense",the switch will not allow claiming the loss or will legally allow the loss to be claimed?

Your response was bit confusing:

'I will offer my uncertified personal view that
substituting a 2X fund tracking the same index as a 1X fund you sold
for a loss does not qualify under the Wash Sale Rule."

My thinking was that to get the 2x leverage,derivatives ,not the underlying securities were used?

TIA

2008 Dec 26 08:29 PM

[QVM Group:]

jbmaria:

You may be correct that 2X funds use derivatives, but use of options, futures and convertible securities on the security you sold do not qualify under the wash sale rule, as I understand it. You should consult your personal tax advisor if you feel that is incorrect, othewise avoid 2X funds of the same index to replace 1X funds.

Richard Shaw

2008 Dec 26 10:40 PM

[jbmaria:]

Thanks again Richard.
You quoted Congress' intent :

"Overall, he pointed out that the intent of Congress in legislation was to prevent investors from recreating the same economic position and risk exposure within the waiting period."

Not to be argumentative but with 2X risk exposure,the argument could be made for the allowance.

But OK,let's say he can't claim the loss. Now what?
How can he recapture a legitimate long term loss on IWM for his return. Is it gone forever or is there a procedure for undoing the damage?

2008 Dec 26 11:15 PM

[QVM Group:]

jbmaria:

You, or you and your tax advisor, will have to make your own determination on any specific transaction as to what is and what is not "substantially identical" under the regulations.

If you can't take a loss due to the Wash Sale Rule, there are cost basis adjustments for the new position. Your tax advisor will be able to calculate that adjustment for you.

2008 Dec 27 10:46 AM

[jbmaria:]

As I continue to beat this dead horse,I ran across this article which I'll post here for informational and archival purposes:

Bankrate.com
Don't let your tax break get washed away
Tuesday January 13, 6:00 am ET
Kay Bell

Your portfolio took a beating, but you were able to use that to your tax advantage by selling some losers. Now one of your former stocks has turned around and you want it back.
In this tax tip:

ADVERTISEMENT

• No loss now, but later
• What exactly is identical?
• IRA swap eliminated

Don't be in too big of a hurry to call your broker. If you repurchase the stock too soon, you'll violate the wash sale rule. This regulation prohibits a shareholder from selling a holding at a loss, using that loss for a tax break and then turning right around and buying the same or similar stock.

It's designed to "prevent the deduction of noneconomic losses," says Selva Ozelli, international tax editor for RIA, a New York-based provider of tax information and software to tax professionals. That's basically what you're trying to do, Ozelli says, if the whole purpose behind a transaction is to generate a tax loss, but you believe in the investment itself.

Most investors encounter the regulation when they reacquire a stock soon after selling, but it works the other way, too.

Specifically, the law says you may not take a tax loss on a security sale if you have obtained the same or a substantially identical security 30 days before or 30 days after a sale. So don't try to get around the rule by buying more of a stock just before you dump the poorly performing shares you already own.

No loss now, but later
When a stock transaction violates wash sale guidelines, the Internal Revenue Service will not let you take the tax break immediately. However, all is not lost.

"The deduction of your loss is postponed to a later date," says Ozelli. That is, the disallowed loss is added to the cost of the new shares you bought. This gives you the tax basis for the holdings, which you'll use when you sell the reacquired securities.

For example, Jim bought 100 shares of Stock A for $1,000 and sold them for $750, producing a $250 loss. Fifteen days later he bought 100 new shares of Stock A for $800. Because Jim bought identical stock, he can't immediately take the loss. But he can add the disallowed $250 to the $800 price of his new shares, producing a basis of $1,050 for the new shares. When Jim sells his reacquired Stock A shares, the adjusted basis will, depending on the sales price, produce a bigger loss to claim or reduce any taxable gains.

What exactly is identical?
The wash sale timing considerations are pretty straightforward. That's not necessarily the case for the rule's other key component: the nature of the sold and repurchased stock.

Investors who deal in individual stocks usually don't have problems. It's easy to tell what stocks the IRS might deem substantially similar. But what about mutual funds?

Let's look at Jim's portfolio again. This time he's closing out his Fidelity XYZ Telecom Fund account at a loss. He believes, however, that the sector is poised for growth so he uses his XYZ proceeds to immediately buy shares of Vanguard ZZZ Telecom Fund. Since both funds are invested in telecom holdings, has Jim violated the wash sale rule?

While technically it looks that way, some tax professionals say Jim is in the clear thanks to IRS vagueness when it comes to wash sales and mutual-fund trading.

"Generally speaking, there are no hard-line guidelines in regard to what is substantially identical in the mutual fund context," says Ozelli. "Rather, the taxpayer has to consider all the facts and circumstances in each case, and there are lots of different interpretations through the courts and private IRS rulings."

Shares issued by different fund groups are not likely to be considered substantially identical, says Ozelli. It gets a little dicier if you shift funds in the same sector within one fund family, for example, going from Fidelity XYZ Telecom to Fidelity Emerging Markets Telecom. Here again, says Ozelli, the facts and circumstances would make the difference, but the IRS would likely take the position that different classes issued by the same fund family are substantially identical.

And, the tax specialist cautions, the IRS always has the power to disregard a sham transaction.

"Even if you made it look like a substantially different security," says Ozelli, "if the IRS identifies that there is no economic substance to the transaction, it will be disallowed."

IRA swap eliminated
Some investors had tried to work around the wash sale rule by buying the sold or similar stock for an individual retirement account, or IRA. In these cases, they argued, because the retirement plan (Roth or traditional) is separate from the taxpayer's individual personal holdings, the wash sale rules shouldn't apply.

The IRS, however, has officially nixed such transactions as a way to circumvent the wash sale rules.

In Revenue Rule 2008-05, published Jan. 22, 2008, the IRS says "if an individual sells stock or securities for a loss and causes his or her IRA or Roth IRA to purchase substantially identical stock or securities within a specified period, the loss on the sale of the stock or securities is disallowed under section 1091, and the individual's basis in the IRA or Roth IRA is not increased by virtue of section 1091(d)."

Essentially, that means the IRS recognizes that the individual investor and the IRA investor are one person, so the wash sale rules apply.

Jan 15 11:53 AM