Some investors seeking to achieve the maximum level of tax efficiency have found the IRS wash sale rule problematic. It postpones the tax advantages of a capital loss to a future time, whereas investors would prefer to enjoy the benefit immediately.
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However, if you can carefully plan your trades, it is possible to effectively navigate the IRS wash sale rule and still achieve desired tax efficiency.
Here’s a look at the wash sale, what it is, and how you can navigate it intelligently:
An Overview of the IRS Wash Sale Rule
When an investor incurs a capital loss on a security (sold for a price less than the purchase price), they can claim that loss against their reported income. This reduces their tax liability for that tax year.
In the past, many investors seeking to reduce their tax liability would take advantage of this provision by intentionally selling assets they intend to keep for a capital loss, only to repurchase them immediately. They could then claim the tax benefits of the capital loss while still holding the asset.
Some investors do this as part of a strategy called tax-loss harvesting. When they realize capital gains on some assets (which is taxable), they also incur capital losses on other assets to reduce their tax liability.
To stem this tide of selling assets solely for tax purposes, the IRS came up with the wash sale rule. Simply put, the rule prohibits selling an asset (e.g., stocks, bonds, mutual funds and exchange-traded funds, or ETFs) for a loss and purchasing a substantially similar asset 30 days before or after the sale. It also applies if investors sell a security at a loss and then purchase an option contract on that same security.
When an investor violates the rule, they will be unable to claim any tax benefit from the capital loss.
This does not mean that the capital loss becomes eternally useless. Instead, it can be applied to the cost basis of the most recent purchase of the asset (or a substantially identical asset). This will increase the cost basis of the asset, reducing the future capital gains, and thus lower the future tax liability.
The holding period of the wash sale security will also be added to the holding period of the repurchased security, making it more likely that the investor will fall into the long-term capital gains tax rate.
Below is an example of the application of the wash sale rule provided by the IRS:
“The taxpayer buys 100 shares of X stock for $1,000. The taxpayer sells these shares for $750 and within 30 days from the sale buys 100 shares of the same stock for $800. Because the taxpayer bought substantially identical stock, the taxpayer cannot deduct the loss of $250 on the sale. However, the taxpayer adds the disallowed loss of $250 to the cost of the new stock, $800, to obtain the basis in the new stock, which is $1,050.”
Navigating the IRS Wash Sale Rule: Useful Tips
Now that you understand how the IRS wash sale rule works, let’s consider some useful tips for navigating it:
Consider Similar but Not Identical Securities
Consider purchasing an ETF if you sold a stock for a loss and want to repurchase it without violating the wash sale rule. The wash sale rule prohibits selling one asset and purchasing a substantially identical one, but you can still buy assets that are somewhat similar.
For example, if you sold Nvidia Corp. (ticker: NVDA) for a capital loss, you could consider purchasing an ETF or index fund that includes NVDA and other similar stocks.
Since you are trying to mirror the performance of NVDA, it is better to choose ETFs that are highly concentrated with holdings that are like NVDA. For example, you could purchase an ETF that tracks the Magnificent 7 stocks, the semiconductor industry or the information technology sector.
Similarly, if you sold an S&P 500 index fund, you could purchase a total market index fund that tracks an index covering the entire U.S. market. Though they are similar, they are not identical.
Stocks of two different companies are also not significantly identical, unless they are predecessor and successor companies involved in a reorganization. So, you can sell Nvidia and purchase Intel Corp. (INTC) or Advanced Micro Devices Inc. (AMD), for instance.
Funds that track the same index but are issued by different providers may not be considered substantially identical. The rule is not very clear on that. Due to the confusion here, it’s better to stick to the three options above.
Be Careful About Securities Issued by the Same Company
There are three securities usually issued by the same company: bonds, preferred stocks and common stocks.
Selling one of these for a loss to purchase another 30 days before or after the sale does not ordinarily result in a wash sale. However, such transactions would be considered a wash sale in the following circumstances:
— If the preferred stock is convertible to a common stock without restrictions.
— If the preferred stockholders have the same voting rights as the common stockholders, in which case they are substantially identical.
— If the preferred stock trades at a price close to the conversion ratio between it and the common stock.
Carefully Plan Your Tax-Loss Harvesting
If you still want to execute a tax-loss harvesting strategy, you can do so with substantially identical assets. All you must do is plan it carefully, so the sale and purchase do not fall into the 30-day window.
At one end, you can wait for 31 days or more before repurchasing the security you have sold. If you prefer to buy before selling, plan to execute the sale at least 31 days after the purchase.
Let’s assume that you intend to compensate for the capital gains on NVDA with capital losses on Quantum Computing Inc. (QUBT). If you sell QUBT on June 1, you should wait until at least July 2 before repurchasing QUBT.
You may have to mark your calendar and set a reminder to avoid violating the rule.
Diversify Your Portfolio for Effective Tax-Loss Harvesting
If your portfolio is already diversified across multiple asset classes and assets, tax-loss harvesting can become easier.
Suppose your portfolio has 10 stocks diversified across various sectors. If you want to realize capital gains on two of them, there is a high probability that there will be unrealized capital losses on at least two of the others. In this case, tax-loss harvesting becomes easy.
However, if you only have three stocks in the same industry, the probability of achieving tax-loss harvesting is lower.
In the same way, if you have stocks, mutual funds and ETFs, you can easily achieve tax-loss harvesting by selling one asset type (selling an S&P 500 ETF, for example) when you have realized capital gains on another asset type (a single stock like NVDA).
Watch Out for Indirect Purchases
If you sell an asset for a capital loss and your spouse or children purchase it (or a substantially identical asset) within 30 days before or after the sale (and vice versa), you will violate the wash sale rule.
Similarly, if you sell an asset at a loss in a taxable account and repurchase it in a tax-advantaged account (including an IRA) within 30 days, you will still be in violation.
If you were planning to use either of these two strategies, forget it.
However, you can also avoid accidental violations by discussing your tax-loss harvesting strategy with your spouse and children. You can convince them to wait for 31 days before repurchasing the asset. Alternatively, you can wait until 31 days after their purchase before you sell.
Watch Out for Dividend Reinvestment Plans
If you currently have a dividend reinvestment plan, or DRIP, you should be wary of accidental violations of the wash sale rule.
There are three options here:
— First, disable DRIP when you are planning to execute a tax-loss harvesting strategy. This will ensure that no accidental violation will occur. But you will have to consider the other tax implications of this approach.
— Second, monitor the stock’s dividend payment date and plan your tax-loss harvesting strategy around it. If the company pays dividends at the end of every quarter, you can avoid accidental violations by selling for capital losses at least 31 days before the dividend payment date.
— Third, plan the sale to occur at least three business days (enough time for the trade to settle) before the ex-dividend date (often publicly available). Once you sell before this date, you will not qualify for dividends.
The wash sale rule can get complicated. As we have seen above, there are still uncertainties around selling a fund from one provider and repurchasing a fund from another provider that tracks the same index.
That example is just one of many ambiguities, which is why, while it’s good to have a basic understanding of the rule, it’s best to consult your financial advisor
while finalizing your tax-loss harvesting strategy.
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How to Navigate the IRS Wash Sale Rule, With Examples originally appeared on usnews.com
