Tax Loss Harvesting And Wash Sale Rule Considerations

Introduction

The stock market has been in a downtrend since the summer but is still up for the year. For fund holders, especially Mutual Funds, you could, or have, experienced capital gain distributions. You might be considering doing some trades to harvest your losses to offset those gains, thus saving on taxes you will owe for this year. Part one of this article covers this strategy and includes some points to consider.

Part two tries to cover the IRS Wash Sale rule. In several recent articles, my mentioning that swapping preferreds from the same company could trigger this and that generated very a lively discussion, most not in agreement with me or other commenters. What that rule is will be covered with what I found but comes with the following disclaimers:

• I am neither a CPA nor tax attorney. When in doubt, consult yours.
• According to numerous sites, the IRS nor Congress, has never definitively defined the key term covering wash sales, that being what a “substantially identical security” means.
• Even different investment sites differ on what is and is not considered a wash sale, with one site having a known factual error.

Before starting, both topics obliviously apply to taxable accounts, but the second drifts into both tax-deferred and spousal accounts.

Tax loss harvesting

I will tackle the easy and less debatable topic first, where one deliberately sells a holding to capture their loss in order to offset gains they already experienced either by selling or via capital gain distributions from a fund they own. I found what I think is a comprehensive definition.

Tax-loss harvesting is a stock investing strategy that attempts to lower the taxes an investor will pay to the U.S. federal government during a current taxable year. The investor activates this strategy by choosing to sell an investment at a loss. They may choose to do this because they expect they will have to take the loss before the end of the year anyway, or perhaps they need the capital right away for a better investment. Whatever their motivation is, they choose to take the loss so that it can offset taxes owed on income, whether from a capital gain or even personal income.

Source: investopedia.com

Now for what investors need to consider before executing the strategy.

• Are you only selling to capture the loss? In other words, you still like the investment. If so, you can buy it back after 30 days to avoid the wash sale rule discussed next. If the stock/fund rallies in the meantime, you might be in worse shape than having held on.
• You can only claim $3000 in net losses in any year ($1500 each if filing married-separate). If you are over that, selling now has no effect on your current year’s tax bill. If you then buy it back, your new cost basis will negatively affect future taxes compared to taking the loss now.
• It might benefit you to capture a loss before it goes long (one year since purchase date) if you short-term gains with no losses to offset them. If your net loss is over your filing limit, the type of loss no longer matters if I got my offset rules right.

If you own mutual funds, some firms have started posted preliminary expected year-end distributions, such as Fidelity has. This helps investors plan for possible year-end activity. Of course, that only matters if held in a taxable account.

Understanding the IRS Wash Sale Rule

First off, if both sides of the trade were done in an IRA-type or similar account where trades are not reported on your 1040, this rule does not apply. For taxable accounts, the only/main benefit is shifting when the loss appears on your tax form (or gain if the stock recovers).

First enacted in 1921, IRS section 1091 had the purpose of preventing taxpayers from recognizing losses without any actual change in their position. The debate over what is and isn't covered stems from the fact Congress wrote the law but left out a specific definition of what would constitutes “substantially identical”, the phrase that generates all the debate! Thus, taxpayers have had to rely heavily on IRS rulings, case law, and their own best judgment to interpret the wash sale rule.

The rule itself is easy to understand except for clarity on that key term that defines what counts as an actual wash sale, the “substantially identical security” clause. I think this link was informative in grasping the issue. It took the SEC 11 pages to explain why Money Market Fund transactions fall outside the IRS rule. Of course, the fact that this was decided by the SEC, not the IRS, also means there are at least two government agencies with their fingers in the wash sale pie! I have tried my best to pick out, without distorting, what is presented in the IRS Pub 550 on this topic where the words "wash sale" appears 37 times!

Let me back up a second and state the rule and why it exists.

Wash sale: A sale of stock or securities at a loss within 30 days before or after you buy or acquire in a fully taxable trade, or acquire a contract or option to buy, substantially identical stock or securities.

A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you: 1. Buy substantially identical stock or securities, 2. Acquire substantially identical stock or securities in a fully taxable trade, 3. Acquire a contract or option to buy substantially identical stock or securities, or 4. Acquire substantially identical stock for your individual retirement arrangement (IRA) or Roth IRA. If you sell stock and your spouse or a corporation you control buys substantially identical stock, you also have a wash sale.

Source: irs.gov Pub 550

That actually makes for a 61-day window as the transaction date doesn't count in either the before/after counts. The definition of the key term comes with its own disclaimer too:

Substantially identical. In determining whether stock or securities are substantially identical, you must consider all the facts and circumstances in your particular case. Ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation. However, they may be substantially identical in some cases. For example, in a reorganization, the stocks and securities of the predecessor and successor corporations may be substantially identical. Similarly, bonds or preferred stock of a corporation are not ordinarily considered substantially identical to the common stock of the same corporation. However, where the bonds or preferred stock are convertible into common stock of the same corporation, the relative values, price changes, and other circumstances may make these bonds or preferred stock and the common stock substantially identical.

Source: irs.gov Pub 550

This table summarizes who has what responsibilities related to possible wash sale activity.

The IRS publication does gives some examples of what is considered a substantially identical security:

• sell common stock at a loss and, at the same time, buy warrants for common stock of the same corporation, but this also comes with an exception. Do the reverse and it might not count.
• sell/buy options to acquire or sell stock or securities. That said, this doesn't apply to futures.
• a bond or preferred stock that is convertible into common stock, has the same voting rights as the common stock, is subject to the same dividend restrictions, trades at prices that do not vary significantly from the conversion ratio, and is unrestricted as to convertibility.

Remember my earlier comment about the debate related to preferreds, my thoughts swapping two from the same issuer could cause a wash sale was incorrect, but again I am not the final word on what is/isn’t.

Substantially identical?

While I think it is clear that swapping ETFs should be safe, even some broker sites are not sure selling and buying this pair wouldn’t be covered by this rule: SPDR S&P 500 ETF (SPY) for Vanguard S&P 500 ETF (VOO). Despite different managers and fees, the concern expressed was they use the same index. While my opinion is if these don’t meet the “substantially identical” definition, what would in terms of swapping ETFs? That said, other sites disagree, using the same two ETFs:

The rationale is that the two S&P 500 ETFs have different fund managers, different expense ratios, may replicate the underlying index using a different methodology, and may have different levels of liquidity in the market. Presently, the IRS does not deem this type of transaction as involving substantially identical securities and so it is allowed, although this may be subject to change in the future as the practice becomes more widespread.

This is how the loss is handled if the IRS decides a trade was a wash sale:

If your loss was disallowed because of the wash sale rules, add the disallowed loss to the cost of the new stock or securities. The result is your basis in the new stock or securities. This adjustment postpones the loss deduction until the disposition of the new stock or securities. Your holding period for the new stock or securities includes the holding period of the stock or securities sold.

Source: irs.gov Pub 550

If the IRS thinks a trade was a wash sale that you did not, you most likely will be sent a bill for taxes owed and then need to adjust your cost on the new holding. In the worst case, you might need to refile a second year’s taxes if you already sold the new asset in a different tax year and filed.

There are some things that I think are clear you cannot do:

• Both the buy and sell is for the same security (think CUSIP) within the 61 day window.
• Sell the same security in one account and buy it in another of your or one of your spouse’s accounts. I tried to verify if that applies if you file married-separate but could not find an answer, maybe a reader knows.

Examples I have seen sites list as outside the scope of this rule include:

• stocks within the same industry
• losses from sales or trades of commodity futures contracts and foreign currencies
• money market accounts as noted above

Examples where one's personal opinion comes into play include:

To me, this paragraph rises additional questions.

More or less stock bought than sold. If the number of shares of substantially identical stock or securities you buy within 30 days before or after the sale is either more or less than the number of shares you sold, you must determine the particular shares to which the wash sale rules apply. You do this by matching the shares bought with an equal number of the shares sold. Match the shares bought in the same order that you bought them, beginning with the first shares bought. The shares or securities so matched are subject to the wash sale rules.

Source: irs.gov Pub 550

I read this to saying the investor has to use FIFO (first in, first out), which is not how I normally trade as I pick which lots were sold. I am sure it does mean you cannot buy within the prior 30 days but sell older shares trying to avoid the wash sale rule, but that is just my understanding.

I am not even entering into a discussion of option trading or short selling as they come with their own set of complicate does/doesn't count rules and exceptions.

Will your broker help identify such trades? Maybe, but IRS regulations only requires them to track and report wash sales on the same CUSIP number within the same account.

Portfolio strategy

“Do not let the tax tail wag your investment strategy dog” is a quote often sited. With the extremely low threshold for writing off investment losses without offsetting gains, it is tempting to capture the maximum each year. While that strategy makes sense, it needs to align with your total investment goals. Remember, taking the loss now changes your tax hit in two years, not one.

As for wash sales, if not properly reported, you owe more taxes now, less later. One article doubted penalties would be applied for underpayment unless the IRS smells something funny. While there is talk that all trades should be sent to the IRS from your brokers, so far that isn’t the law, thus the IRS spotting a wash sale, I feel, is suspect.

There might even be times you want to execute trade that is a wash sale, such as selling at a loss before an expected bad earnings report, and buying the shares back after the news seems reflected in the stock price. If so, selling 15 days before and buying back 16 days after the announcement is a possible tactic. If the report comes out better than expected, you can re-enter and treat it as a wash sale.

Final thought

Here are just a few of the sites I viewed in trying to decipher the complexity of the wash sale rule. There were many more and suspect many will be posted in comments. The topics here beg for great comments to complete the picture.

Wash-Sale Rules | Avoid this tax pitfall | Fidelity

Wash Sale Challenge: What Is Substantially Identical?

https://www.forbes.com/advisor/investing/wash-sale-rule/

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