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Tax Loss Harvesting – A strategy to share your losses with the U. S. Treasury

John J. FureyOctober 1, 2015

Taxes

What is tax loss harvesting and why do it?

Tax loss harvesting involves selling securities that have realized losses. The losses can be used on your tax returns in the following three ways: 1) to offset any taxes due on capital gains; 2) to reduce other ordinary income by up to $3,000 per year; and 3) to carry over to future tax years to be used to offset capital gains and reduce other ordinary income up to $3,000.

It is an opportunity created by the tax law, not market speculation that can be used to reduce your taxes due to the IRS. After you sell a security in your portfolio at a loss, the security can be replaced by a similar, but not substantially identical, security to maintain your asset allocation goals. This should allow you to immediately save taxes when you file your tax return.

An example of tax loss harvesting

On January 2, 2015 an investor purchased security A for $100,000. On August 25, 2015 the investor sold security A for $85,000 for a loss of $15,000, and immediately reinvested the $85,000. The investor has $10,000 of capital gains from other investments in 2015. On the 2015 tax return the investor uses $10,000 of the loss to offset the capital gains of $10,000, saving $2,000 in taxes assuming the investor is in the highest tax brackets of 20% for capital gains and 39.6% for ordinary income. The investor uses an additional $3,000 of the loss to reduce ordinary income resulting in an additional $1,188 in tax savings.  On the 2016 tax return the investor uses the remaining carryover of $2,000 of losses to offset capital gains of $2,000 for a tax savings of $400. Total tax savings could be as high as $3,588 depending on your tax bracket.

By using tax loss harvesting the investor has a federal tax savings return of 3.6% on the $100,000 investment in Security A. The investor may also have a state tax savings return depending on whether or not the investor’s state taxes capital gains.

What is the wash sale rule and why does it matter when doing tax loss harvesting?

The wash sale rule in the Internal Revenue Code prevents an investor from deducting any loss from the sale of a security if the investor purchases “substantially identical stock or securities” within 30 days before or after the date of the sale. The three key concepts in the rule are 1) sale of “stocks or securities;” 2) purchase of “substantially identical stocks or securities,” or certain derivatives of the stock or securities; and 3) the 61 day period on either side of the loss sale. The purchase of the security in the investor’s IRA counts as a purchase under the rule.

The purpose of the rule is to prevent a taxpayer from recognizing a loss on the sale of securities while maintaining an identical or nearly identical investment position. The security does not have to be exactly identical for the rule to apply. If the security leaves the taxpayer in the same economic position as prior to the sale, then the rule will apply because the taxpayer is in a nearly identical investment position. Investment risk and the wash sale rule are tied together. If the taxpayer completely eliminates investment risk by selling a security at a loss and purchasing a nearly identical security within the 61-day period, the taxpayer will likely have a wash sale, and thus not be eligible to deduct the loss.

The rule was first included in the Code by Congress in 1921 to close what was considered one of the first “abusive” tax loopholes. The rule was straightforward in the 1920s, when for example an investor sold 1,000 shares of IBM on day 1 for a loss of $10,000 because the price had declined by $10 from the purchase date and on day 5 bought 1,000 shares of IBM at the lower stock price. The rule prevented the taxpayer in this example from taking the $10,000 capital loss on the tax return because the taxpayer maintained an identical investment position.

The problem today with the wash sale rule is that neither Congress, nor the Treasury, nor the IRS has provided a clear definition of “substantially identical.” The rule is not straightforward with the rise of pooled investment vehicles like mutual funds and index ETFs.

In former IRS Publication 564, the IRS acknowledged that “ordinarily, shares issued by one mutual fund are not considered substantially identical to shares issued by another mutual fund.” However, the IRS did not provide any clarification about under what circumstances two mutual funds could be substantially identical. Generally, mutual funds have kept their “ordinarily not substantially identical” treatment because of differences in underlying holdings, management and costs.

A key distinction between ETFs and mutual funds is the management of the funds. ETFs are benchmarked to specific indexes and maintain their connection to the index. Swapping index funds that track the exact same index would almost certainly trigger the wash sale rule.

Investment advisors have developed the following list of transactions that are generally considered to be acceptable to avoid the wash sale rule:

  1. Sell one index fund and buy another index fund, if the indexes of the two funds are not the same (e.g. S&P 500 for Russell 1000).
  2. Sell one actively managed fund and buy a fund at another company with different portfolio managers.
  3. Sell an index fund and buy an actively managed fund regardless of the fund company.
  4. Sell an actively managed fund and buy an index fund regardless of the fund company.

Please consult your financial advisor or tax professional about tax savings strategies that could be beneficial to your financial situation.

 

Sources

Garrett M. Fischer, New Twists on an Old Plot: Investors look to Avoid the Wash Sale Rule by Harvesting Tax Losses with Exchange-Traded Funds, 88 Wash. U. L. Rev. 229 (2010).

Michael E. Kitces, Does Tax Loss Harvesting “Almost” Substantially Identical Mutual Funds and ETFs Trigger a Wash Sale Problem? (May 6, 2015).

Fairmark Guide to Wash Sales.