Fall is tax-loss harvesting season. Between now and December 31, selling securities which are currently worth less than you paid for them will result in “realized” capital losses. Capital losses are valuable because they offset realized capital gains on profitable trades. Or, if you don’t have capital gains this year, you can use losses to offset up to $3,000 of ordinary income. Ordinary income examples include wages, salary, tips, and interest income. Taxpayers can carry capital losses above $3,000 of ordinary income forward for use in future years. “Wash sales” are one important pitfall that can undermine a sound capital loss harvesting strategy.

Having Your Cake and Eating it Too

One problem arises immediately: what if an investment that currently has an unrealized loss is now more attractively priced? Should you sell if you believe the price will improve? Selling and immediately buying the investment back would be convenient. However, the IRS discourages trading simply for tax benefits. Thus, the wash sale rule: in selling a security at a loss, you cannot buy a substantially identical security within 30 days. If you do, it would “wash away” the realized capital loss.

Strategies that Won’t Work

“Substantially identical” is the operative wording in wash sales. But the precise meaning is somewhat vague. It certainly covers the same security – for example selling Apple stock and buying it back within 30 days. The IRS has offered guidance on other strategies that constitute substantially identical, including

  • Buying call options on a stock within 30 days of selling the stock itself
  • Selling shares of a fund or stock in a taxable account and buying it back within 30 days in an IRA
  • Using an index ETF issued by a different company. IRS Publication 550 says “Ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation.”  However, the IRS might judge that two securities issued by separate sponsors but containing substantially identical underlying securities are constructively themselves substantially identical. For this reason, we don’t recommend it. Please check with your tax advisor for specific guidance.
Strategies to Consider

Exchange traded funds (“ETFs”) help avoid wash sales while maintain similar economic exposure. Here are two to keep in mind:

  1. Utilize a similar index ETF. The Vanguard FTSE Emerging Markets ETF (VWO) is one of the largest emerging market ETFs. It’s down 20% since the end of January as of this writing. The iShares Core Emerging Markets ETF (IEMG) is another of the largest, and also down roughly 20%. Both ETFs have broad emerging market stock exposure, but they also each track two different indexes.
  2. Use a sector ETF as a stock replacement. Some unlucky investor has the unenviable distinction of buying Netflix stock at its all-time high price of $418.65. The stock is currently trading at $341.50, or a loss of 18%. Netflix is a member of the S&P 500 Consumer Cyclical sector. The ETF representing that sector trades as the symbol XLY. While Netflix could certainly rise more than 18% in a month after selling, XLY would also benefit from a Netflix rebound, though not as much.
Conclusion

The IRS means exactly what they appear to mean by “substantially identical.” Over the course of 31 days while you wait, maintain substantially similar exposure through use of related ETFs. It is important to stay fully invested, as market timing typically results in poor long-term performance.

Disclosures

Peloton Wealth Strategists does not own the common stock of Apple, Inc. (AAPL), Netflix, Inc. (NFLX),  the Consumer Discretionary Select Sector SPDR ETF (XLY), Vanguard FTSE Emerging Markets ETF (VWO), or  iShares Core Emerging Markets ETF (IEMG) in its managed portfolios.  The opinions expressed above should be construed as neither investment advice nor a solicitation to buy or sell securities.  Peloton Wealth Strategists assumes no liability for losses pursuant to investment actions entered into as a result of opinions expressed herein.  Changes in economic and capital market conditions and the unique objectives of each investor should be considered before investing in securities. Please consult your tax advisor for specific recommendations.