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Financial Planning > Tax Planning > Tax Loss Harvesting

The Murky Side of Tax-Loss Harvesting

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What You Need to Know

  • Recent reporting by ProPublica has highlighted the way some major investors violate the spirit, if not the letter, of IRS anti-wash sale rules.
  • The wash sale rules are meant to discourage inappropriate use of tax-loss harvesting to avoid paying what can be very significant amounts of taxes.
  • Sources in the advisory industry say the real problem is that the century-old wash sale rules are vague and need to be updated.

An article published Feb. 9 by ProPublica put a spotlight on the apparent abuse of wash sale rules by a number of highly prominent investors, including Steve Ballmer, the former Microsoft CEO.

According to ProPublica’s reporting, Ballmer managed to harvest just shy of $580 million in losses between 2014 and 2018. While eye-popping, the amount of the losses harvested is not the focus of ProPublica’s analysis.

Rather, the story raises big questions about the ways in which at least some of the losses were apparently generated, and it also posits that the practice of tax-loss harvesting is ripe for abuse by ultra-wealthy investors who have access to the most sophisticated investment advisors and consultants.

Since the article’s publication, ThinkAdvisor has been soliciting comments from a range of financial advisors and other financial industry professionals who pride themselves on the delivery of highly tax-efficient investment approaches to their clients. According to the pros, the transactions reported on by ProPublica do indeed seem to violate the spirit, if not the letter, of the Internal Revenue Service’s anti-wash sale rules.

However, the advisors took issue with the broader characterization of tax-loss harvesting as a strategy that is inherently problematic from a tax-fairness perspective, and they equally took umbrage with the suggestion that loss harvesting is something that is only available to the wealthiest or most sophisticated investors. In today’s marketplace, many middle-class and mass affluent investors can and do take advantage of loss harvesting as a means to minimize taxes and maximize wealth generation.

Ultimately, according to the experts, it is important for investors and their professional advisors to consider the both the regulatory and reputational risk that can come along with “overly aggressive” attempts to harvest losses and then quickly reinvest in similar strategies. As Ballmer’s case shows, just because a given transaction could arguably be called legal, that does not mean it won’t generate scrutiny or liability if the IRS comes knocking.

What ProPublica’s Reporting Found

As ProPublica reports, in one transaction in July 2015, Ballmer allegedly dumped hundreds of stocks, losing at least $28 million, including by selling shares of the Australian mining company BHP and the global oil giant Shell. The problem is that Ballmer also allegedly bought thousands of shares in BHP and Shell on the same day.

On the face of it, this move would seem to plainly violate the anti-wash sale rules put in place by the IRS in 1921. Put simply, the wash sale rules forbid the selling of a security at a loss for the tax benefits if the seller then quickly buys back the same or a substantially similar security to benefit from its anticipated future performance.

In Ballmer’s case, the specific share types sold and purchased were technically different, according to ProPublica, despite the fact that they were issued by the same companies. This difference apparently gave Ballmer and his Goldman Sachs advisors reason to believe they were not violating the wash sale rules.

According to ProPublica, by using similar strategies, Ballmer was eventually able to generate tax losses totaling $579 million without meaningfully changing his investment portfolio. The estimated tax savings from these losses amount to at least $138 million.

The article suggests various other prominent investors working with Goldman Sachs and other firms have engaged in similar activities, collectively generating billions in harvested losses over a period of five years.

Notably, with the emergence of the media scrutiny, Ballmer and others have committed to amend their previous tax filings and to pay any associated taxes, interest or penalties promptly. Goldman Sachs has also reportedly halted certain trading activities in response to the reporting.

What Industry Pros Have to Say

While the main focus of the ProPublica article is the apparent abuse by Ballmer of technical loopholes that exist in the current wash sale rule framework, the article also raises questions about the fairness of tax-loss harvesting itself, and whether such strategies exist purely for the benefit of the wealthiest and most financially savvy Americans.

Asked for his thoughts on the issue, Andy Watts, vice president of investment solutions at Avantax, a firm specializing in tax-aware wealth management, had a lot to share, starting with the fact that tax-loss harvesting can benefit any long-term investor, especially those focused on preparing for retirement.

“It is important for anyone who is planning, accumulating and withdrawing assets for retirement to have some tax registration diversification,” Watts says. “When you are doing retirement planning right, you’re going to have taxable dollars. In that sense, there’s no debate. The average American absolutely should be using tax-loss harvesting.”

Watts says tax-loss harvesting is “absolutely not something that just benefits the uber-wealthy.” According to Watts, many middle-class and mass-affluent Americans could actually better position themselves for retirement by not only relying on tax-deferred investment vehicles such as 401(k) plans or individual retirement accounts.

Instead, investors often can benefit by diversifying their wealth across taxable and tax-advantaged accounts, and if the right support resources are there, it almost always makes sense for investors to consider loss harvesting in their long-term taxable accounts.

“This is why Avantax, and our tax and financial professionals, believe that every financial decision fundamentally is a tax decision, and that’s why we’re committed to tax-advantaged financial and retirement planning for all Americans,” Watts says.

Outdated Wash Sale Rules

Anton Honikman, the CEO of MyVest, agrees wholeheartedly with that take, telling ThinkAdvisor that the real issue identified by ProProblica is the outdated wash sale rules rather than the general idea of loss harvesting.

“It’s just a reality that, as long as there is a complex tax code, there will always be sophisticated actors trying to exploit loopholes,” Honikman says. “That’s not something specific to loss harvesting and wash sales. It’s a far bigger issue that applies across the entire tax code, and so specifically taking issue with loss harvesting isn’t going to solve the real problem at hand.”

Honikman says his gut tells him that the kind of trades reported on in the ProPublica story were “pretty risky” and clearly in violation of the spirit of the wash sale rules, whether or not they were technically illegal.

“That’s one key takeaway from this issue for advisors and their clients,” Honikman suggests. “You may feel like something is within bounds, but an IRS auditor may take a look at your choice down the road and have a different interpretation. So, one conclusion from this article is that some people are taking a lot of reputational or regulatory risk with their interpretation of the wash sale rules.”

Honikman says the evidence is clear that the wash sale rules are due for an update.

“This part of the tax code was written more than 100 years ago, before the advent of mutual funds or multiple share classes being issued of the same stock,” Honikman points out. “And the rules came to be so many years before the creation of exchange-traded funds, as well, which add yet another layer of complexity. As such, I’m very much in favor of getting more clarity and refinement to the rules.”

Like Watts, Honikman says technology-based platforms like Avantax and MyVest are getting better and better at allowing advisors to “democratize” what have long been investment strategies exclusively made available to wealthier investors.

“It’s exciting to be working in this space, because we can help to deliver scalable solutions that allow people to loss harvest at scale — while satisfying both the letter and the spirit of the law,” Honikman says. “And the spirit of the law is not about selling share class A and buying share class B.”

Looking forward, Honikman suggests the IRS could take the approach of pushing wash sale rule enforcement more firmly into the hands of investment services providers, for example by making them directly liable for violations.

“At this stage, we only really see enforcement in really egregious cases of high-profile individuals,” Honikman observes. “Because the providers are in the business of rebalancing portfolios, it could make sense to move in that direction.”

(Image: Adobe Stock)


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