ETF - open secret - cap gains tax loophole

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Earl Lemongrab
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Re: ETF - open secret - cap gains tax loophole

Post by Earl Lemongrab »

Thesaints wrote:SPY is not substantially identical to IVV, but 50% of the underlying securities are. The IRS would have an easy case, if they wanted to go after individual investors.
That doesn't make the slightest sense. The securities being sold are the ETFs, not the underlying anything. The question is whether the two funds are substantially identical.

I know from past posts you have an idiosyncratic way of looking at things, so I'm not going to bother with further engagement with you on this. I think you're wrong in your analysis. That doesn't mean that your conclusion is necessarily wrong, just the argument for it.
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Re: ETF - open secret - cap gains tax loophole

Post by Thesaints »

Earl Lemongrab wrote:
Thesaints wrote:SPY is not substantially identical to IVV, but 50% of the underlying securities are. The IRS would have an easy case, if they wanted to go after individual investors.
That doesn't make the slightest sense. The securities being sold are the ETFs, not the underlying anything. The question is whether the two funds are substantially identical.

I know from past posts you have an idiosyncratic way of looking at things, so I'm not going to bother with further engagement with you on this. I think you're wrong in your analysis. That doesn't mean that your conclusion is necessarily wrong, just the argument for it.
An ETF is a container of securities. Two containers can be non identical, but they can certainly contain (some) securities which are identical.
In fact, I can bring a certain blend of securities to the ETF issuer, obtain ETF shares in exchange (and vice versa), and the IRS calls this a redemption in kind, which is prima facie evidence that ETF shares and underlying securities are one and the same.

One can choose to become agitated, or try to understand things.
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Re: ETF - open secret - cap gains tax loophole

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Thesaints wrote:In fact, I can bring a certain blend of securities to the ETF issuer, obtain ETF shares in exchange (and vice versa), and the IRS calls this a redemption in kind, which is prima facie evidence that ETF shares and underlying securities are one and the same.
Let's try it from that viewpoint. The ETF provider is making a redemption in kind. There is no sale or buying of the underlying securities so a wash sale is a non sequiter. On the other side of the transaction the authorized participant has to buy or sell those shares that it is exchanging. Whether or not the buying or selling is a wash sale depends on whether or not it has a loss or maybe because it is a "trader" it operates under different rules and any gain or loss is ordinary income and the wash sale idea is a non issue.

We are only concerned with the ETF side.
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Re: ETF - open secret - cap gains tax loophole

Post by Thesaints »

I'm not sure you appreciated the fact that, if VOO and SPY are not substantially identical securities and if SPY and IVV are not considered as being substantially ideantical for half the amount, then a large entity, such as Wealthfront, could harvest losses in their clients' accounts without ever incurring the WSR.

For the individual investor point of view, do you agree that selling $100 worth of SPY and buying $50 each of IVV and IVW is a wash sale ? If you don't, how about selling $10M and buying $5M each ? And if you are not yet convinced, how about selling $10M worth of S&P 500 stocks, cap weighted, and buying the same stocks but keeping $5M in one account and $5M in another' ?
Incidentally, those large amounts correspond to 2 creation units of SPY and 1 each of IVV and IVW and for the IRS it is absolutely irrelevant if you trade those securities individually, or variously grouped under an ETF umbrella.

The only reason why, up to now, the IRS has not gone after the $100 investor is that it is not worth it. They didn't go after overseas accounts for more than 50 years either.
Last edited by Thesaints on Thu Jul 13, 2017 10:49 am, edited 1 time in total.
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Re: ETF - open secret - cap gains tax loophole

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Thesaints wrote:The only reason why, up to now, the IRS has not gone after the $100 investor is that it is not worth it. They didn't go after overseas accounts for more than 50 years either
What source do you have for "The only reason"? Are they going after a Wealthfront? If they were we would know about it. And they would use the resulting court case if in their favor to issue a ruling for all those $100 people like us. Whether they put a lot of effort in it is another matter. But they would publish the results if nothing else but to try to get compliance through fear of an audit.

If you have any source that two or any combination of funds following different indexes are substantially identical please share that source with us.
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Re: ETF - open secret - cap gains tax loophole

Post by Thesaints »

They don't go after Wealthfront because at Wealthfront they are not so naive to try a move like that.
You don't need to read "sources"; just read the Law and be sure to understand what an ETF is. It is all written there and quite clearly, I may add.
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Re: ETF - open secret - cap gains tax loophole

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OK you made me find my own source.

"Does Tax Loss Harvesting “Almost” Substantially Identical Mutual Funds And ETFs Trigger A Wash Sale Problem?"
In former IRS Publication 564, the Service acknowledged that “ordinarily, shares issued by one mutual fund are not considered to be substantially identical to shares issued by another mutual fund”, but without any clarification as to what circumstances two mutual funds could be substantially identical.
Ultimately, there will no doubt be a large number of “grey” and murky situations, but I suspect that until the IRS provides better guidance (or Congress rewrites/updates the wash sale rules altogether!), in the near term the easiest “red flag” warning is simply to look at the correlation between the original investment being loss-harvested, and the replacement security; at correlations above 0.95, and especially at 0.99+, it’s difficult to argue that the securities are not ”substantially identical” to each other in performance.
https://www.kitces.com/blog/the-wash-sa ... -and-etfs/

And from the horses mouth itself:
IRS Publication 564 wrote:Ordinarily, shares issued by one mutual fund are not considered to be substantially identical to shares issued by another mutual fund.
If one is really worried about this I would suggest pairing a large cap fund with a mid-cap fund or something long those lines for 30 days. Remember you only defer the loss it doesn't disappear completely in a taxable account.
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Re: ETF - open secret - cap gains tax loophole

Post by Thesaints »

And didn't I write that ETF's are a slam dunk, but with funds it would be a lot harder ?

Which does not mean, however, that playing the old switcharoo between VTMGX and VEURX + VPADX is kosher under scrutiny.

All those rules mentioning 99%, 85%, etc. are in-house rules chosen in a CYA optics. The IRS never specified a quantitative definition of "substantially".
Mind you this is a completely different topic from the exchange SPY for IVV where 50% of the underlying is 100% identical.
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Re: ETF - open secret - cap gains tax loophole

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Thesaints wrote: The IRS never specified a quantitative definition of "substantially".
Right, but when they do have an example it is generally like selling a stock and buying a call on the exact same stock. There is absolutely no risk. In the IRS descriptions "substantially" refers to the fact that the pair are different instruments although they have exactly the same market risk.

As far as I can tell the IRS has not addressed the mutual fund situation except for the Pub 564 instructions.

If you are trying to claim a distinction between a traditional Mutual Fund and an Exchange Traded Fund you are really deep into speculation in my opinion.

Enough. The way things are going I won't be doing any TLH in the foreseeable future.
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Earl Lemongrab
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Re: ETF - open secret - cap gains tax loophole

Post by Earl Lemongrab »

Doc wrote:The way things are going I won't be doing any TLH in the foreseeable future.
Well, I'm happy to do TLH because I have carryover losses in the five-figure range (thanks to starting my taxable portfolio in 2007). If the IRS called me on a wash sale between two ETFs, it would a) mean nothing to me tax-wise, b) make me famous on Bogleheads and probably elsewhere. So as I said, I will volunteer to TLH IVV and VOO should the opportunity arise. I should buy a few shares of IVV at Merrill Edge now so that I have some with high basis.

Also, I don't think we're getting any clarification from the IRS until the actual law changes. I don't think they care very much about it. They have lots bigger problems, like fraudulent returns sending millions in tax revenue to eastern Europe and Russia.
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Re: ETF - open secret - cap gains tax loophole

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alex_686 wrote:When I worked with a investment management company, they asked us to keep records so we could justify that there was not a substantial overlap.

They did not care about economic exposure. If you overlaid 2 different charts and got similar results that did not matter.

They asked us to generate and retain reports showing the overlap at the weighted holdings level. They wanted to know what the overlap was. VOO and VV would have a high overlap so that probably would count as substantial overlap. The number that we came up with was 85% - if the overlap was greater than 85% than it was substantially similar. Other people I have worked with in the industry also uses that number. We can look at the court cases that IRS has brought and the opinions that they have issued.
Your company was absurdly conservative and irrational; there are no cases no support this nonsense. Please stop confusing people. And it's not "substantially similar" but "substantially identical."
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Re: ETF - open secret - cap gains tax loophole

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Earl Lemongrab wrote:Doc wrote:
The way things are going I won't be doing any TLH in the foreseeable future.

Well, I'm happy to do TLH because I have carryover losses in the five-figure range (thanks to starting my taxable portfolio in 2007). If the IRS called me on a wash sale between two ETFs, it would a) mean nothing to me tax-wise, b) make me famous on Bogleheads and probably elsewhere. So as I said, I will volunteer to TLH IVV and VOO should the opportunity arise. I should buy a few shares of IVV at Merrill Edge now so that I have some with high basis.
I'm not doing any TLH in the near future because I don't have any losses. :D But if I did I would have no concern replacing IVV with VOO.

IVV market cap 88 million, VOO 67 million - 24% or 31% different depending on which way one looks.
IVV ~500 stocks, VOO ~1000 stocks - 50% or 100% different depending on which way one looks.
They are substantially different.

Somewhere in researching this topic I found a reference that two bonds with different coupons but the same maturity date were not substantially identical yet the yield on both is almost exactly the same. The fact that two different assets have the same return over some arbitrary time period does not make them identical.
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Re: ETF - open secret - cap gains tax loophole

Post by Thesaints »

Doc wrote:If you are trying to claim a distinction between a traditional Mutual Fund and an Exchange Traded Fund you are really deep into speculation in my opinion.
Then I have to doubt you have an intimate understanding of what an ETF is.
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Re: ETF - open secret - cap gains tax loophole

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Thesaints wrote:
Doc wrote:If you are trying to claim a distinction between a traditional Mutual Fund and an Exchange Traded Fund you are really deep into speculation in my opinion.
Then I have to doubt you have an intimate understanding of what an ETF is.
The question is whether the IRS treats traditional mutual fund differently for tax purposes. Vanguard's ETF's are share classes of their mutual funds. Are you suggesting that the IRS treats admiral shares differently from investor class shares? And if so does the IRS make this distinction without informing tax payers explicitly that the different share classes are subject to different tax regulations?
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Re: ETF - open secret - cap gains tax loophole

Post by triceratop »

Doc wrote:
Thesaints wrote:
Doc wrote:If you are trying to claim a distinction between a traditional Mutual Fund and an Exchange Traded Fund you are really deep into speculation in my opinion.
Then I have to doubt you have an intimate understanding of what an ETF is.
The question is whether the IRS treats traditional mutual fund differently for tax purposes. Vanguard's ETF's are share classes of their mutual funds. Are you suggesting that the IRS treats admiral shares differently from investor class shares? And if so does the IRS make this distinction without informing tax payers explicitly that the different share classes are subject to different tax regulations?
Your post here in this very useful thread was clarifying on this point. Exchanging from admiral to investor shares is a non-taxable event (according to you and some other analysis linked to in that thread) so the wash sale problem doesn't really come up.
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Re: ETF - open secret - cap gains tax loophole

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triceratop wrote:
Doc wrote:
Thesaints wrote:
Doc wrote:If you are trying to claim a distinction between a traditional Mutual Fund and an Exchange Traded Fund you are really deep into speculation in my opinion.
Then I have to doubt you have an intimate understanding of what an ETF is.
The question is whether the IRS treats traditional mutual fund differently for tax purposes. Vanguard's ETF's are share classes of their mutual funds. Are you suggesting that the IRS treats admiral shares differently from investor class shares? And if so does the IRS make this distinction without informing tax payers explicitly that the different share classes are subject to different tax regulations?
Your post here in this very useful thread was clarifying on this point. Exchanging from admiral to investor shares is a non-taxable event (according to you and some other analysis linked to in that thread) so the wash sale problem doesn't really come up.
Vanguard wrote:Can I convert my conventional Vanguard mutual fund shares to Vanguard ETF Shares?
Yes. Most funds that offer ETF Shares will allow you to convert from conventional shares of the same fund to ETF Shares. (Four of our bond ETFs—Total Bond Market, Short-Term Bond, Intermediate-Term Bond, and Long-Term Bond—don't allow for conversions.)
Conversions are allowed from both Investor and Admiral™ Shares and are tax-free if you own your mutual fund and ETF Shares through Vanguard.
I take this to mean that as far Vanguard is concerned the tax treatment of ETF's and traditional mutual funds is the same. If this were not true certainly we would know about it. The conversion to ETF is apparently a transfer in kind for fund owners just as the the stocks to ETF shares is to authorized participants.

From the December 2016 annual report for Vanguard 500 Index Fund p28
During the year ended December 31, 2016, the fund realized $6,081,373,000 of net capital gains
resulting from in-kind redemptions—in which shareholders exchanged fund shares for securities
held by the fund rather than for cash. Because such gains are not taxable to the fund, and are not
distributed to shareholders, they have been reclassified from accumulated net realized losses to
paid-in capital
.
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Re: ETF - open secret - cap gains tax loophole

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Doc wrote:I'm not doing any TLH in the near future because I don't have any losses. :D
Fairly common "problem" at this time.
Doc wrote:But if I did I would have no concern replacing IVV with VOO. IVV market cap 88 million, VOO 67 million - 24% or 31% different depending on which way one looks.
IVV ~500 stocks, VOO ~1000 stocks - 50% or 100% different depending on which way one looks.
I think you mean VV (Large Cap) there. VOO is the Vanguard S&P 500 ETF. I'm willing to swap two SP500 ETFs because there's no tax impact if I did get called on it (I wouldn't) as long as it's all in taxable accounts.
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Re: ETF - open secret - cap gains tax loophole

Post by triceratop »

Earl Lemongrab wrote: I think you mean VV (Large Cap) there. VOO is the Vanguard S&P 500 ETF. I'm willing to swap two SP500 ETFs because there's no tax impact if I did get called on it (I wouldn't) as long as it's all in taxable accounts.
I sincerely wish you "luck" in your IRS encounters. :beer :wink:
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Re: ETF - open secret - cap gains tax loophole

Post by Thesaints »

Vanguard's ETF are different from all the others, being defined as share class of mutual funds.
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Re: ETF - open secret - cap gains tax loophole

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Earl Lemongrab wrote:Doc wrote:
But if I did I would have no concern replacing IVV with VOO. IVV market cap 88 million, VOO 67 million - 24% or 31% different depending on which way one looks.
IVV ~500 stocks, VOO ~1000 stocks - 50% or 100% different depending on which way one looks.

I think you mean VV (Large Cap) there. VOO is the Vanguard S&P 500 ETF. I'm willing to swap two SP500 ETFs because there's no tax impact if I did get called on it (I wouldn't) as long as it's all in taxable accounts
:oops: multiple typo's I was tying to compare a Russell 1000 to an S&P 500 which I did. I just "made up" the tickers as I typed the post.

I tend to TLH with two pairs. Sell equity and buy bonds in taxable and sell bonds and buy equities in ROTH. Hence I need to be very careful not to have a wash sale. But since I am going to reverse the position in 30 days I can allow quite a bit of "not anywhere near identical" because I'm going to reverse the trades in a short time. I once tried the equity to another not so close equity fund both in taxable and am still stuck in the less desirable alternative after several years.
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Re: ETF - open secret - cap gains tax loophole

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Thesaints wrote:Vanguard's ETF are different from all the others, being defined as share class of mutual funds.
Similar type comment in SPDR® S&P 500 ETF SPY annual report.
Units are issued and redeemed by the Trust only in Creation Unit size aggregations of 50,000 Units. Such transactions are only permitted on an in-kind basis, with a separate cash payment that is equivalent to the undistributed net investment income per Unit (income equalization) and a balancing cash component to equate the transaction to the NAV per Unit of the Trust on the transaction date
There is a Morningstar article discussing the "in-kind" concept:
Exchange-traded funds also may pay off departing shareholders by conducting "in-kind" transactions. When a large ETF investor, called an authorized participant, wants to sell its shares, the ETF can give the institution its money back in the form of securities held in the portfolio. In this way, the ETF can flush out highly appreciated securities in its portfolios (that is, those with a low cost basis), helping to improve the ETF's tax efficiency.
http://ibd.morningstar.com/article/arti ... /archive.a
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Re: ETF - open secret - cap gains tax loophole

Post by Thesaints »

Doc wrote:
Thesaints wrote:Vanguard's ETF are different from all the others, being defined as share class of mutual funds.
Similar type comment in SPDR® S&P 500 ETF SPY annual report.
Units are issued and redeemed by the Trust only in Creation Unit size aggregations of 50,000 Units. Such transactions are only permitted on an in-kind basis, with a separate cash payment that is equivalent to the undistributed net investment income per Unit (income equalization) and a balancing cash component to equate the transaction to the NAV per Unit of the Trust on the transaction date
There is a Morningstar article discussing the "in-kind" concept:
Exchange-traded funds also may pay off departing shareholders by conducting "in-kind" transactions. When a large ETF investor, called an authorized participant, wants to sell its shares, the ETF can give the institution its money back in the form of securities held in the portfolio. In this way, the ETF can flush out highly appreciated securities in its portfolios (that is, those with a low cost basis), helping to improve the ETF's tax efficiency.
http://ibd.morningstar.com/article/arti ... /archive.a
I'm not sure what you are trying to demonstrate.
Yes, "in-kind". Transacting a creation unit of SPY is equivalent to transacting so many shares of AAPL, so many of MSFT, so many of FB,... down to so many of R. It is not me who says that, but the IRS when they say that such an exchange is non taxable.
And we are back to my original question: If I sell $100 worth of AAPL and immediately buy $50 worth of AAPL and $50 worth of GOOG, am I triggering the WSR for half of my assets, or are you saying that AAPL+GOOG is not substantially identical to AAPL ?
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Re: ETF - open secret - cap gains tax loophole

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triceratop wrote:
Earl Lemongrab wrote: I think you mean VV (Large Cap) there. VOO is the Vanguard S&P 500 ETF. I'm willing to swap two SP500 ETFs because there's no tax impact if I did get called on it (I wouldn't) as long as it's all in taxable accounts.
I sincerely wish you "luck" in your IRS encounters. :beer :wink:
There'd be nothing to fear. Besides the notoriety, all that would happen is a 1040-X that changes Schedule D to readjust the losses and change the carryover loss number. If I felt like it, I could contact the custodian and see about transferring the loss basis to the "replacement" shares.
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Re: ETF - open secret - cap gains tax loophole

Post by triceratop »

Earl Lemongrab wrote:
triceratop wrote:
Earl Lemongrab wrote: I think you mean VV (Large Cap) there. VOO is the Vanguard S&P 500 ETF. I'm willing to swap two SP500 ETFs because there's no tax impact if I did get called on it (I wouldn't) as long as it's all in taxable accounts.
I sincerely wish you "luck" in your IRS encounters. :beer :wink:
There'd be nothing to fear. Besides the notoriety, all that would happen is a 1040-X that changes Schedule D to readjust the losses and change the carryover loss number. If I felt like it, I could contact the custodian and see about transferring the loss basis to the "replacement" shares.
I meant I was hoping you would get nabbed by the IRS and achieve fame and fortune ;)
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Re: ETF - open secret - cap gains tax loophole

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Thesaints wrote:And we are back to my original question: If I sell $100 worth of AAPL and immediately buy $50 worth of AAPL and $50 worth of GOOG, am I triggering the WSR for half of my assets, or are you saying that AAPL+GOOG is not substantially identical to AAPL ?
You are triggering a wash sale for 50 shares. The G sold is exactly identical to the G sold. This is spelled out in the published info and is not in question. (Whether brokers are complying correctly is another question.)

Taking this concept and applying it to a fund is another matter. The only guidence provided by the IRS is what I quoted up thread from the Pub 564 that said explicitly that "ordinarily, ... " shares of one mutual fund are not substantially identical to shares issued by another.

If the IRS has changed it's position on this in keeping with your idea we would all know about it. In practice the IRS has published regs requiring only funds with the same cusip to be reported which implies that nothing has changed from Pub 564.
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