jbmaria

Tax Loss Harvesting & the 'Wash Sale' Rule

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:

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• 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.

Tax Loss Harvesting & the 'Wash Sale' Rule

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?

Tax Loss Harvesting & the 'Wash Sale' Rule

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

Tax Loss Harvesting & the 'Wash Sale' Rule

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?

The Anatomy of a Bear Market

Nice quotes,little substance. Most of us know bear markets end,we need to know when?
But,are you sure it's not different this time? After all,it's the first time in my knowledge for the toxicity engendered by highly leveraged CDOs.

Why I'm Not Worried About the Market

"The heavy metal poisoning that the gold bugs use to usurp the power of confidence and the principles of authority with that of primitive idolatry will start to diminish over time."

Yeah, everything "diminishes" over time,I need to know when.
With stocks 'early" is just "wrong".