Wash sale

A wash sale is a sale of a security (stocks, bonds, options) at a loss and repurchase of the same or substantially identical security (judging by CUSIP or Committee on Uniform Securities Identification Procedures numbers) shortly before or after.[1] Losses from such sales are not deductible in most cases under the Internal Revenue Code in the United States.[2] Wash sale regulations disallow an investor who holds an unrealized loss from accelerating a tax deduction into the current tax year, unless the investor is out of the position for some significant length of time. A wash sale can take place at any time during the year, or across year boundaries.

Not to be confused with Wash trade.

In the United Kingdom, a similar practice which specifically takes place at the end of a calendar year is known as bed and breakfasting. In a bed-and-breakfasting transaction, a position is sold on the last trading day of the year (typically late in the trading session) to establish a tax loss. The same position is then repurchased early on the first session of the new trading year, to restore the position (albeit at a lower cost basis). The term, therefore, derives its name from the late sale and early morning repurchase.[3]

Wash sale rules don't apply when stock is sold at a profit.[4] A related term, tax-loss harvesting is "selling an investment at a loss with the intention of ultimately repurchasing the same investment after the IRS's 30 day window on wash sales has expired." This allows investors to lower their tax amount with the use of investment losses.[5] Wash sales and similar trading patterns are not themselves prohibited; the rules only deal with the tax treatment of capital losses and the accounting of the ongoing tax basis. Tax rules in the U.S. and U.K. defer the tax benefits of wash selling at a loss. Such losses are added to the basis of the newly acquired security, essentially deferring the tax benefits until a non-wash sale occurs, if ever.

Identification

According to the Merriam-Webster Legal Dictionary, the legal definition is "a sale and purchase of securities that produces no change of the beneficial owner."[2] The IRS broadened its definition of wash sales in 1993.[6] In the United States, wash sale laws are codified in "26 USC § 1091 - Loss from wash sales of stock or securities." The corresponding treasury regulations are given by CFR 1.1091-1 [7] and 1.1091-2.[8]

Under Section 1091, a wash sale occurs when a taxpayer sells or trades stock or securities at a loss, and within 30 days before or after the sale:[9][10]

  1. Buys substantially identical stock or securities,
  2. Acquires substantially identical stock or securities in a fully taxable trade,
  3. Acquires a contract or option to buy substantially identical stock or securities, or
  4. Acquires substantially identical stock for an individual retirement account (IRA).

The "substantially identical stock" acquired in any of these ways is called the "replacement stock" for that original position. The IRS has not formally defined what "substantially identical" funds are constituted of.[5]

Consequences

In the United States, the wash sale rule has the following consequences:

  1. The taxpayer is not allowed to claim the loss on the sale (the loss is not "realized").
  2. Basis Adjustment: The disallowed loss is added to the cost basis of the replacement stock.
  3. Holding Period: The holding period for the replacement stock includes the holding period of the stock sold.[11]

In the United States, reporting wash sale loss adjustments is done on the 1099-B form.[12] According to Forbes, "most brokers don't report wash sale (WS) loss calculations during the year." For the IRS, taxpayers in the United States must calculate their WS losses "across all taxpayer's brokerage accounts, including IRAs and spousal accounts if married/filing joint.[13] Wash sale rules can also be avoided by "not buying a security within 30 days of selling the same one or a similar one for a loss."[14]

Basis adjustment

After a sale is identified as a wash sale and if the replacement stock is bought within 30 days before or after the sale then the wash sale loss is added to the basis of the replacement stock. The basis adjustment preserves the benefit of the disallowed loss; the holder receives that benefit on a future sale of the replacement stock. However, if the replacement shares are in a tax-advantaged account, such as an IRA, the disallowed loss cannot be added to the basis and there is no benefit for the loss.[15] The identification of a wash sale and adjusting the basis of the replacement stock is an iterative process. Thus, the sale of the replacement stock (after its basis is adjusted) can also be identified as a wash sale if it meets the above criteria. Because of the basis adjustment in taxable accounts, the wash sale rule usually does not have a significant impact there. In most cases, it simply means the benefit will be reflected on a later report.

Holding period

When a wash sale occurs, the holding period for the replacement stock includes the period you held the stock sold.

Tax loss harvesting

Tax loss harvesting (TLH) is a technique for "generating" capital losses. It occurs when an investor sells a security that has depreciated in value.[16][17] CBS News describes tax-loss harvesting specifically as "selling an investment at a loss with the intention of ultimately repurchasing the same investment after the IRS's 30 day window on wash sales has expired." This allows investors to lower their tax amount with the use of investment losses.[5] Tax-loss harvesting can be done throughout the fiscal year, allowing investors to "offset capital gains with capital losses."[18] If an investor has more capital losses than gains in a year, that year they can use up to $3,000 as a deduction to "offset ordinary income," with the remainder carrying over into future years if unused.[19] Loss harvesting defers taxes, but doesn't eliminate them, and is essentially receiving a loan without interest from the federal government, assuming marginal tax rates are the same.[20] If marginal rates are different, then there can be additional tax savings (e.g., deducting excess losses against a higher ordinary income rate in one year in exchange for additional long term capital gains tax at a lower rate in a later year) or even a tax penalty (e.g., deducting at a lower capital gains tax rate in several years in exchange for a much larger gain in one later year that puts one in a higher capital gains tax and Medicare investment income tax bracket.)[21]

Most simply, if "tax-loss harvesting is not done properly, it will create a wash-sale that will eliminate the tax benefits of the buying and selling."[22] The investor can employ a number of techniques to avoid triggering the wash sale rule.

  1. The investor can wait 30 days to repurchase the security[23]
  2. The investor can purchase a security that is similar to the original, but that does not meet the IRS's definition of "substantially identical". For example, an investor can sell an ETF and buy another with similar investment objectives.[24]

Most tax-loss harvesting historically has been performed in December.[25] Tax-loss harvesting is still most common in the year's fourth quarter. The practice has been both praised and criticized by investors, as deferring the taxes can result in higher rates later on relating to capital gains.[21]

Investment companies

The IRS has published no exact definition of what constitutes a "substantially identical" security. Therefore, it is not clear whether or not the securities of different investment companies can be "substantially identical", even if their investment objectives are identical. As a result, if an investor trades in and out of ETF's or mutual funds with almost identical holdings, some have held that it does not trigger the wash sale rule.[26][27]

For example, State Street's SPDR S&P 500 ETF (NYSEARCA: SPY)[28] and iShare's Core S&P 500 ETF (NYSEARCA: IVV)[29] both track the S&P 500. If an investor purchases shares in SPY and the market price declines, the IRS has not provided guidance on whether the investor can sell their shares in SPY, purchase shares in IVV, and claim a capital loss without triggering the wash sale rule, despite the fact that the two ETF's have nearly identical returns.

Mean-variance portfolio optimization

With an initial set of portfolio weights and benchmark weights , it is possible to do TLH within the confines of mean-variance optimization by developing an objective function[30] that maximizes the difference between tax alpha and the portfolio's tracking error:[31]

where is a penalty term for excess tracking error and is the covariance matrix of asset returns. For each asset that is bought/sold, it is necessary to include the constraints:

With this formulation, the TLH optimization may be applied within a mean-variance framework. The solution is readily computed using quadratic programming.

See also
  • Ex-dividend date, where favorable tax treatment of qualified dividends is contingent on a 60-day holding period, similar to the wash sale rules.
  • Round-tripping, a type of accounting fraud practiced through asset swapping, resembling wash sales within a group of participants.

References
  1. "Internal Revenue Code Sec. 1091".
  2. Wash Sale, Merriam Webster
  3. "What is bed and breakfast deal? definition and meaning". BusinessDictionary.com.
  4. 'Wash Sale' Rules Aren't for Profits, Wall Street Journal
  5. Help with Tax-Loss Harvesting, CBS News
  6. IRS broadens the definition of wash sales: can Cottage Savings carry the day?, CPA Journal
  7. "CFR 1.1091-1". Retrieved 1 April 2015.
  8. "CFR 1.1091-2". Retrieved 1 April 2015.
  9. "Investment Income and Expenses" (PDF). IRS Publication 550. 2011. p. 60. Retrieved 14 Sep 2012.
  10. Thomas, Kaye A. (April 8, 2011). "Wash Sales 101". Tax Guide for Investors. Fairmark Press Inc. Retrieved 14 Sep 2012.
  11. IRS Publication 550 - Investment Income and Expenses - Wash Sales
  12. "Wash Sale Loss Adjustments Can Be A Big Tax Return Headache", Forbes
  13. "How To Avoid Taxes On Wash Sale Losses", Forbes
  14. The Motley Fool: 'Wash sale' rule and what it means, Seattle Times
  15. Thomas, Kaye A. (December 20, 2007). "Wash Sales and IRAs". Tax Guide for Investors. Fairmark Press Inc. Retrieved 22 May 2018.
  16. Charles Schwab: Tax Loss Harvesting
  17. Rebalance with ETFs to Avoid Wash-Sale Rule, CNBC
  18. Year-end tax planning: the race for tax-loss harvesting, Reuters
  19. The best way to cut your stock market losses, CNN
  20. Assessing the true value of tax-loss harvesting, AP News
  21. Weighing the pros and cons of annual tax-loss harvesting, CNBC
  22. "How To Lower Your Taxes With Tax Loss Harvesting", Forbes
  23. For Clean Tax Loss on Stock, Heed 'Wash Sale' Rule, Chicago Tribune
  24. Wealthfront: Tax Loss Harvesting
  25. "Why You Should Tax-Loss Harvest Now", Forbes
  26. Tax Rules for ETF Losses Fidelity.com
  27. Substantially Identical Security Investopedia
  28. State Street SPDR S&P 500 ETF
  29. iShares Core S&P 500 ETF
  30. Tembine, Hamidou; Duncan, Tyrone E. (March 2018). "Linear–Quadratic Mean-Field-Type Games: A Direct Method". Games. 9 (1): 7. doi:10.3390/g9010007.
  31. Moon, Avery (2014). "Tax Efficient Portfolios" (PDF). R/Finance 2014.
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