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.
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.