As the end of the year approaches, the annual exercise of pruning losers from your clients' portfolio to declare a tax-loss will soon be front and center.
Let's say, however, that you think the long-term prospects for a stock are still positive and you want them to maintain their exposure. Something known as the "wash sale rule" will nullify their ability to declare the capital loss if you reestablish their position too soon. Losses can be helpful in terms of offsetting gains in other capital assets and reducing tax liability.
The wash sale rule says that if you sell a stock at a loss, you must wait 30 days before you can repurchase the same stock in order to be able to declare the loss on your tax return. If you were to repurchase before the 30-day period elapses, the loss is disallowed, and the value of that disallowed loss is added to the cost basis of the subsequent purchase. Your holding period for the new stock includes the holding period for the previously held stock. This feature prevents long-term losses from being reclassified as short-term losses, which would offset ordinary income dollar for dollar.
This next point was covered in my last article for Boomer Market Advisor in which the wash sale rule applies to the IRA. There was a recent IRS Revenue Ruling, 2008-5, which clarified that you may not sell a stock at a loss in a taxable account and then repurchase the same stock within your IRA within the 30-day window. This was a maneuver that was previously recommended by advisors in order to skirt the wash sale rule. The IRS has finally ruled that this is in fact a wash sale and will be treated as such.
Although I have been using stocks as examples, the tax code states that the rule also applies to "substantially identical" securities. For example, selling a stock for a loss and buying a call option on the same stock within the 30-day window is considered as a "substantially identical" security transaction. You can also apply this definition to mutual funds. If you sell an S&P 500 Index Fund at a loss, and then buy a different S&P 500 Index Fund or an S&P 500 ETF, the spirit of the rule applies, and the IRS says you have, in essence, not changed your position relative to the market.
Here's an additional tidbit to ponder. The wash sale rule waiting period applies to the 30 days prior to the sale as well. Let's say your client has owned 100 shares of Microsoft since last year at a current loss. They buy an additional 100 shares today and sell the old 100 shares for a loss next week. They have bought replacement shares that were sold within the 30-day window, and the IRS will not allow that loss.
Being aware of the restrictions the wash sale rule imposes will create an opportunity to provide additional value to your clients. Identifying and selling losing stocks within a portfolio is never fun, but at the very least, you need to make sure that the client gets the benefit of the tax loss.
Mark A. Cortazzo, CFP is senior partner with MACRO Consulting Group in Parsippany, N.J.