While turmoil in financial markets is unnerving to say the least, there is usually a silver lining somewhere. Yes, it Is disheartening when portfolios are down, but the silver lining some active investors choose to take advantage of is to exit positions with limited tax impact. In fact, many investors opt to benefit from depressed values by “harvesting tax losses.” In other words, investors may seize the opportunity to recognize an unrealized loss in their investments. Sure it sounds straightforward, but investors may want to proceed with caution to avoid running afoul of the wash sale rule imposed by IRC 1091.
Capital Gain and Losses Background
Capital gains and losses can be either short-term or long-term. Capital assets held for more than 12 months are considered long-term. Gains or losses are considered short-term if the assets are held for 12 months or less. This distinction is important because long-term capital gains are typically taxed at a more favorable rate than short-term gains taxed at ordinary income rates.
A netting process must take place before determining the amount of tax due. Short-term capital gains and losses for the year are netted against each other. Then, the same is done for long-term gains and losses. Lastly, the net capital gain or loss is netted against the net long-term capital gain or loss. Up to $3,000 of excess capital losses can offset ordinary income. Capital losses exceeding $3,000 are carried forward to future years.
Tax Loss Harvesting
As you can see through the netting process, capital losses can help reduce potential gains owed on capital gains. You probably noticed the word potential was used. This is because there is a chance some or all of a taxpayer’s capital gains are taxed at zero percent if one’s taxable income is low enough. It is important to note, however, that capital gains are still counted toward adjusted gross income even if they are taxed at a lower rate, but this aspect is probably another blog post.
With a tax saving incentive, taxpayers could be tempted to sell an investment they like just to recognize an unrealized loss. However, the IRS is smarter than that and has closed that loophole. According to IRC 1091, losses are disallowed when a taxpayer purchases the same stock or security or a contract or options to purchase substantially identical stock or securities within a 61 day period including 30 days before and after the sale or disposition of said stock.
Example 1: On April 1st, Ted has an unrealized loss of $10,000 on XYZ stock. So, he decides to sell XYZ to potentially use the loss later in the year to offset any possible capital gains. Ted actually likes the stock because he thinks its long-term growth prospects are good, but he really wants to recognize the loss. Unfortunately, he did not know about the sale rules and purchased XYZ two weeks later on April 15th. This transaction is considered a wash sale and the loss is disallowed.
Ted learned the hard way, but the following year he believes he found another loophole. He finds himself in a similar situation with ABC stock, but this time, he buys the stock in his IRA the day after he sells at a loss in his brokerage account. Revenue Ruling 2008-5 considers this to be a wash sale, too.
It is important to note that the old IRS Publication 564 states, “Ordinarily, shares of one mutual fund are not considered substantially identical to shares issued by another mutual fund.” However, this is about as much guidance that is given with regard to mutual funds and the wash sale rules. Equally as unknown is how exchange-traded funds are viewed. This code section predates the advent of ETFs. While it is to reach the conclusion that different mutual funds can truly be different given the fact that you have a manager that could be managing a fund completely different than its competitors. Consider S&P 500 ETFs, on the other hand, two different providers could easily have substantially identical holdings. Hopefully, the IRS will give guidance on how the wash sale rules applies to these vehicles rapidly growing in popularity. If not, maybe Congress will amend this Code provision to catch up to the times.
This material was created for educational and informational purposes only and is not intended as tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF's net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors.