How to Advise Clients on Wash Sale Rules

There isn’t much to get excited about when the stock market plummets — unless you’re staring down a large capital gains bill. Since the IRS allows investors to deduct capital losses from their gains to reduce their tax bill, a market decline can present a handy tax-loss harvesting opportunity.

Longer term investors may be tempted to take advantage of a market dip by selling stocks at a loss, then repurchasing them later, thus counteracting some capital gains without losing their position. But tempting as this may be, it doesn’t always work out the way an investor intends.

“Depending on the timing of their reentry and what investments they choose to buy, it’s very possible that when they go to file their taxes for 2020, they’ll have some unpleasant news regarding those losses they thought they had realized, due to the wash sale rule,” says Jack Clark, senior wealth advisor at The Colony Group.

Here’s what to know about wash sale rules and how to advise clients on this investing and tax concept.

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What Is the Wash Sale Rule?

A wash sale occurs when an investor buys a security that is substantially identical to one she sold or traded at a loss 30 days before or after the sale. For example, if you sold ABC stock at a loss and repurchased it 27 days later, the trade would trigger a wash sale. If you waited to repurchase ABC until 31 days after your first trade, however, a wash sale would not be triggered.

According to the wash sale rule, investors are not allowed to deduct the loss from a wash sale. “The intent of the wash sale rule is to prevent an investor from claiming ‘artificial’ loss,” says Daniel Milan, managing partner of Cornerstone Financial Services. It essentially prevents investors from “gaming the system by realizing losses on securities they actually intend to hold by merely moving in and out of the security to reestablish lower costs basis and, at the same time, deduct any losses.”

[Read: Financial Advisors Eye Biden’s Plan for Estate Taxes in 2021]

Does the Wash Sale Rule Apply to Mutual Funds, Options and Other Investment Products?

The wash sale rule applies to stocks, mutual funds and exchange-traded funds. It can also apply to options and futures contracts to buy or sell a stock, but does not apply to losses on trades of commodity futures or foreign currency. The rule applies to warrants if an investor sells a stock at a loss and buys a warrant for stock for the same corporation’s common stock. Selling a warrant at a loss and buying the same corporation’s common stock only triggers a wash sale if the warrant and stock are considered “substantially identical.”

“While ‘substantially identical’ is an ambiguous term, the goal is to prevent investors from owning a largely identical security as the one that had been sold,” says Dan Fasciano, national director of portfolio management at BNY Mellon Wealth Management.

In the words of the IRS: “In determining whether stock or securities are substantially identical, you must consider all the facts and circumstances in your particular case.” For the most part, securities from different corporations are not substantially identical enough to trigger a wash sale except in certain situations, such as a reorganization where the stock of the predecessor corporation may be substantially identical to that of the successor corporation.

Bonds or preferred stock are generally not considered substantially identical to common stock of the same corporation unless they are convertible into common stock, in which case they may be substantially identical depending on factors such as their relative value or price changes, according to the IRS.

[READ: Should You Get a Financial Advisor’s Advice Before Investing in Bitcoin?]

What Are the Tax Implications of a Wash Sale?

The tax implications of a wash sale rule are simple: “Due to the wash sale rule, the loss you thought you had realized at the time of the sale cannot be deducted,” Clark says. “Instead, the loss is disallowed and added to the basis of the repurchased security.”

This can cause you to end up with a larger tax bill than anticipated this year. That said, the longer term economic benefit is not entirely forgone, Fasciano says. “The eliminated loss can be applied to the cost basis of the newly purchased security, making a loss or reduced gain more likely on a subsequent sale.”

How to Advise Clients on the Wash Sale Rule

The best advice to give a client on the wash sale rule is to avoid triggering a wash sale. There are essentially two ways an advisor can do this, Milan says. First, if your client is a long-term investor, she can easily avoid the wash sale rule by holding the security for the long term, regardless of short-term volatility.

Second, if your client is determined to reestablish her cost basis, have her wait to repurchase the security until 31 days after her sale or later. “Obviously, there is risk involved in that strategy, as a lot can happen within 30 days, but if they wait the 30 days, then the wash rule falls off,” Milan says.

So what to do in the meantime? “The easiest solution is to invest elsewhere for 30 days, for example, another company’s stock,” Clark says. “Many investors and advisors use placeholder securities, such as another company’s stock in the same sector or industry as a stock that was just sold, or an ETF that tracks a similar but different index, (for example) an S&P 500 fund versus a Russell 1000 fund.”

But here you’d need to be careful that the other investment is not “substantially identical.” This becomes particularly difficult with mutual funds and ETFs, which can hold the same securities.

“Because the IRS has not defined exactly what substantially identical means for every circumstance, the obligation falls on the taxpayer to justify any transactions that might be questioned by the IRS for reporting on this rule,” Clark says.

You should also keep tabs on all your client’s trades and accounts. Remember that the 30-day window applies both forward and back, so it’s really a 61-day window that starts 30 days before the sale and ends 30 days after.

Likewise, since the wash sale rule applies across investor accounts, “advisors should have a holistic understanding of client assets and any overlap in ownership between various accounts, including when investors choose to work with multiple advisors,” Fasciano says.

If a wash sale is triggered, the most you can do is help your client ensure the cost basis of the new security is adjusted accordingly, so she can potentially capture a future loss or reduce her future gain, he says. Beyond that, all you can do is educate your client to prevent a wash sale from occurring.

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