All investors experience losses, no matter how experienced or knowledgeable they are. The Internal Revenue Service (IRS) allows investors to deduct capital losses from investing gains in order to reduce your capital gains taxes. Under the IRS rules, short-term capital losses can be used to reduce short-term capital gains, which is extremely beneficial because short-term capital gains tax is equal to your ordinary income tax rate. It’s not unheard of for short-term capital gains to be taxes as high as 35%, so having the ability to reduce your short-term capital gains with short-term capital losses can make a big difference at tax time.
IRS Wash Sale Rules
The IRS created the Wash Sale Rule to prevent investors from taking advantage of capital losses. The basic rule is this: if you sell a stock or security and re-buy the same stock within 30 days, you can’t claim it as an investment loss at tax time. You also can’t buy the stock option or call as those transactions are prohibited under the Wash Sale Rule, too.
How to Offset Capital Gains with Losses – and Avoid the Wash Sale Rule
The IRS rule states you can’t buy the same stock or investment within 30 days, or another investment that is substantially similar. For example, you can’t sell an index fund from Vanguard that is based on the S&P 500 and replace it with an index fund from Fidelity that is also based on the S&P 500. Even though the investments are technically different, they are substantially similar.
But that doesn’t mean investors can’t find another investment that is in the same ball park. One way to take advantage of this is to invest in the same sector. For example, many industries tend to fluctuate at similar intervals within a 30 day period. You might see stock indexes and similarly structured mutual funds (like large-cap funds) move up and down at similar intervals in any 30 day time period. It can be fairly easy to find a replacement investment if you primarily invest with ETFs, mutual funds and index funds.
Example: If you were to watch the S&P500 Index and compare it to the S&P1000 Index over a period of 30 days or so, you’ll see that they move in close proportion to one another. Take a look at this chart for example.
This chart tracks the S&P 500 (blue) and the S&P 1000 (orange) for the month of October, 2010. As you can see, the exact gains and losses aren’t exactly the same, but they are in the same ballpark. The next chart covers the same two indexes over a 60 day period.
As you can see, there is a more pronounced difference in the gains, but again, they are in the same ballpark.
If an investor needs to offset their investment gains with investment losses without running into problems under the IRS Wash Sale Rule, they could sell an S&P500 Index Fund and then purchase a S&P1000 ETF. The overall amount will be different, but when looking at percentages they are probably going to be very close. This will both avoid problems under the Wash Rule and still give you the opportunity to offset your gains with losses.
The difference in your investment returns using this strategy is a small price to pay when the effect of creating the short-term capital loss to offset your gains can save you capital-gains taxes of 30 to 35%.
Final note: This is just an example of a situation which may work. You should do further research before investing and contact an investment professional if you have additional questions.