In an ideal world all of your investments would gain 10% per year indefinitely. A nice, solid source of growth that you could throw as much investment money as you wanted at. Unfortunately we all know that is not the case; investments gain and fall. 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 taxed 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.
Thankfully when we invest in stocks, ETFs, mutual funds, and bond investments we can get a bit of a tax break if we incur an investment loss. However, as with any tax deduction, we have to be careful not to make a mistake that results in our loss of that deduction. A common example is the wash sale rule.
What is the Wash Sale Rule?
The IRS created the Wash Sale Rule to prevent investors from taking advantage of capital losses. The wash rule prevents an investor from selling an investment at a loss today, deducting that loss, and reinvesting in the same, or a substantially similar, investment tomorrow (or within a certain time frame). It is a limiting period of time where you cannot reinvest in the same or substantially similar investment.
The basic rule is this: if you sell a stock or security and re-buy the same stock or security 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.
The period of time you must wait to reinvest is 30 days from when you sell the investment. If you repurchase the investment or one very similar to it, you will lose the ability to deduct the loss no matter what price you repurchased the shares at.
This is the basic understanding of the wash rule. What you may not know is the rule is much more complicated than that.
How the Wash Sale Rules Really Works for Investments
Here are some of the specifics on how the wash sale rule applies to selling investments at a loss and repurchasing similar shares in the future.
30 Day Wash Sale Rule
Most people understand the wash sale to mean you have to wait 30 days after the sale of a security before repurchasing a substantially similar investment. That is only part of the rule.
The wash rule is actually 61 days: the day of the sale, 30 days after the sale, and 30 days before the sale.
How it works is best seen through an example.
Let’s say you buy 50 shares of ABC Company at $30 per share today. Next week, you buy 25 more shares because you really like the company. Thirty one days after your initial purchase you sell your original 50 shares at $25 per share, a loss of $5 per share. You claim this loss on your your taxes, and much to your surprise the IRS says it doesn’t count as a wash sale. Why? Because you purchased shares within 30 days before the sale of the stock.
What is a Substantially Identical Security?
This is where things can be a bit tricky.
Obviously, you can’t sell shares in ABC Company and buy ABC company within the 61 day period without hitting the wash sale rules. But what about similar companies? Can you sell Exxon Mobile and purchase shares of Chevron? Although the companies are similar, they should not be considered substantially similar. Although they are in the same industry, one could company be having a banner year and the other could have masses losses due to the expenses of dealing with a large oil spill.
Things get even more tricky when it comes to ETFs and mutual funds that focus on a specific index. Low cost index investments follow the exact same set of investments, so it could be argued they are substantially similar. If you sell Vanguard’s S&P 500 Index Fund (VFINX) and buy Fidelity’s Spartan 500 Index Fund (FUSEX) does the wash rule apply? The answer is most likely yes.
Unfortunately the IRS regulations aren’t specific down to individual investments, and the wording isn’t 100% clear. Be cautious.
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%.
Fairmark Press offers a very detailed breakdown of several different scenarios that involve the wash sale rule for investments. If you need further guidance, consult with an investment advisor or professional tax advisor. The added expense is well worth avoiding an audit!