Tax Loss Harvesting & the 'Wash Sale' Rule

by: Richard Shaw

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 (NYSE:GM) at a loss and buy Ford (NYSE: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, 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 (NYSEARCA: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 (NYSEARCA:IVV) (iShares S&P 500) or VFINX (Vanguard S&P 500).

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

Scenario C:

Purchases (NYSEARCA:IWB) (iShares Russell 1000) or (NYSEARCA:IWV) (iShares Russell 3000) or (NYSEARCA: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

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