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Financial Planning > Tax Planning > Tax Loss Harvesting

In Tax-Loss Harvesting, Step Carefully Through the ‘Wash Sale’ Minefield

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What You Need to Know

  • Advisors who harvest tax losses must beware of the substantially identical rule that could trigger a wash sale.
  • The rules on wash trades are vague; advisors need to be careful when buying similar stocks within 30 days.
  • Mutual funds and ETFs add another layer of tricky comparisons for advisors.

Smart advisors work year round to tax harvest their client accounts instead of waiting until the fourth quarter. The reason is the ability to book more losses for tax reasons.

But there’s a trick to the process, writes Sheryl Rowling, CPA, who is head of rebalancing solutions for Morningstar and founder of Rowling & Associates, an investment advisory firm, in a recent column, Wash Sale Challenge: What is Substantially Identical?

The Internal Revenue Service considers a “wash sale” when a stock is sold at a loss and bought back — or a “substantially identical” security is — within 30 days of the sale. This means the loss deduction isn’t allowed.

But what exactly does “substantially identical” mean, and how does this apply to mutual funds and exchange-traded funds? After all, Rowling notes, there are nuances in the IRS rule and advisors also need to understand what it means by “facts and circumstances.”

As a result, advisors do one of two things: sell the stock to harvest the loss and stay out of it for 30 days, and/or they purchase a substitute stock to avoid any opportunity loss of being out of the stock. She cites the example of selling Apple and then buying Microsoft.

What’s Identical?

The vagueness of the definition of “substantially identical” has meant “taxpayers have had to rely heavily on Revenue Rulings, case law, and their own best judgment to interpret this vague rule,” Rowling writes. She notes that one tool to decipher this is the “facts and circumstances” test, which says a taxpayer should look at the entire context of a situation before reaching a conclusion.

OK, not exactly crystal clear, but the IRS does state that “ordinarily stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation,” and the same applies to bonds.

But what about applying these rules to mutual funds and ETFs, which haven’t been addressed by the IRS except in Publication 564 — discontinued in 2009 — that stated that “ordinarily” shares of one mutual fund are not considered substantially identical of another mutual fund?

According to Rowling, financial planner and blogger Michael Kitces has said that differences in proportions of the underlying securities, how the fund is managed, and the identity of the fund manager “have been enough to allow the mutual fund market, for the most part, to operate without fear of triggering wash sales.”

But she worries about the opacity of the guidelines and notes that “to use tax-loss harvesting strategies with mutual funds, it is essential that investors and their advisors establish a personal set of parameters to provide a measure of assurance against wash sales.”

Straddles and the 70% Rule

Here’s one recommendation: Look to option straddles. She writes that “a potentially ‘safe’ definition of not substantially identical mutual funds can be gleaned from the straddle rules. The Code of Federal Regulations contains a more definitive set of guidelines when establishing similarity in relation to an option straddle. ….

“The code states ‘a position reflecting the value of a portfolio of stocks is substantially similar or related to the stocks held by the taxpayer only if the position and the taxpayer’s holdings substantially overlap as of the most recent testing date” (Treasury Regulation 1.246-5). In order to avoid being substantially related, the fund sold at a loss must have equal to or less than 70% overlap with the tax-loss harvesting alternative. Although the 70% line applies to straddles, it could be useful when comparing mutual funds.”

But that means evaluating each fund. Some differences seem easy: different managers, different styles (ie. active versus passive), but if these cases were similar and holdings were the same above that 70% bar, this “could pose a higher risk of wash sale,” she says.

This means advisors must weigh all relevant features when tax-loss harvesting with mutual funds and ETFs.