Wash sale

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This page summarizes the issue of wash sales for mutual fund and ETF investors, but IRS Publication 550 remains the definitive reference. Fairmark guide to wash sales is also an excellent source of information. Wash sales are particularly relevant for investors who are tax loss harvesting.

General description
If you sell a mutual fund or stock held in a taxable account for less than the purchase price, you have a capital loss, and you can usually report this as a loss and subtract it from your income. However, if you sold the shares and then bought them right back, or bought new shares and then immediately sold the old shares, the IRS will rule that you did not really sell them, and will not allow you to deduct the loss at that time.

IRS definition
A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:


 * 1) Buy substantially identical stock or securities,
 * 2) Acquire substantially identical stock or securities in a fully taxable trade,
 * 3) Acquire a contract or option to buy substantially identical stock or securities, or
 * 4) Acquire substantially identical stock for your individual retirement account (IRA) or Roth IRA.

26 U.S. Code § 1091 provides the official text for wash sale rules. The only exception is for dealers of stocks or securities.

Revenue Ruling 2008-05 clarifies that § 1091 does indeed apply to replacement purchases in IRA and Roth IRA accounts and states that "This ruling does not address any issues other than those specifically addressed herein". RR 2008-05 referenced Security First Nat'l Bank v. Commissioner, which involved a taxpayer attempting to use a trust to evade the wash sale law, as well as Shoenberg v. Commissioner of Internal Revenue, which involved a taxpayer attempting to use a corporate account to evade the wash sale law.

The IRS has not specifically ruled that other tax sheltered accounts, such as 401(k) or 403(b) accounts, are exempt from wash sale rules.

If you sell stock and your spouse or a corporation you control buys substantially identical stock, you also have a wash sale.

If your loss was disallowed because of the wash sale rules, add the disallowed loss to the cost of the new stock or securities (except in tax sheltered accounts ). The result is your basis in the new stock or securities. This adjustment postpones the loss deduction until the disposition of the new stock or securities. Your holding period for the new stock or securities includes the holding period of the stock or securities sold.

Consequences
If you have a wash sale, you do not deduct the loss immediately, but you add the loss to your basis in the new shares, so that you can deduct the loss when you sell those shares. It is still better to take the loss earlier, as it produces an immediate benefit; in addition, a wash sale negates the value of tax loss harvesting.

For example, you bought 100 shares of a mutual fund at $40. On March 1, you sold 100 shares at $30. On March 10, you bought 100 shares at $35. Your sale on March 1 was a wash sale, so you could not deduct the $1,000 loss at the time, but your basis in the March 10 shares is $4,500, not $3,500, so you will reduce your capital gains or increase your losses when you sell those shares.

If you have a wash sale and the replacement shares are a tax-sheltered account, such as an IRA or Roth IRA, you will lose all benefit from the capital loss (there is no mechanism for basis adjustment and you do not pay capital gains tax in a tax-sheltered account).

Irrelevant wash sales
A brokerage's computer can report a wash sale when a single transaction is split into two, but this wash sale has no effect on your final position. For example, you bought 100 shares of stock on February 1 at $40, and 100 shares on March 1 at $45. You sell both lots on March 10 at $35. The brokerage first records the sale of the February 1 lot, creating a wash sale with the March 1 lot; the $500 loss is not deductible at the time but the basis of the March 1 lot is increased to $5,000. The brokerage then records the sale of the March 1 lot, for a capital loss of $1,500, the same total as if there had been no wash sale.

How to avoid wash sales
You can avoid a wash sale by avoiding either criterion: either make sure that you buy any replacement shares at least 31 days before or after the sale, or buy replacement shares that are not substantially identical.

30-day limit
To avoid the 30-day limit, do not reinvest dividends or capital gains in your taxable funds. Otherwise, the reinvestment will cause a wash sale (for at least the shares bought with the reinvestment) if you sell the fund at a loss within 30 days of the distribution; this will affect a sale for eight months of the year if the fund pays dividends quarterly, and at all times if the fund pays dividends monthly. (If you use Specific identification of shares, you can avoid the effect of a wash sale on a reinvestment in the last 30 days by selling those shares; even if your brokerage says that you have a wash sale, you retain the loss because you sold the replacement shares at the same time.)

If you are tax loss harvesting, you need to wait at least 31 days before buying the fund back. For those 31 days, put the money in a money market or in a similar fund that is not substantially identical.

If the consequences of the wash sale are acceptable in your situation, there is no need for a waiting period and you can sell the replacement shares immediately.

If you hold the same fund in your IRA as in your taxable account, make sure that there are no recent contributions to that fund if you might want to sell your taxable fund at a loss. Direct distributions in the IRA to a different fund in the same account.

Substantially identical
The IRS does not have a clear definition of substantially identical; it is determined by all the facts and circumstances in a particular case. Two share classes of the same fund, such as a mutual fund and a corresponding ETF, are probably substantially identical, since they are as close to identical as possible, without being identical. There is no ruling on whether two funds operated by different companies tracking the same index are substantially identical; tax experts have differing opinions. The Supreme Court ruled that the IRS cannot use the concept of an "economic substitute" in determining if two investments are substantially identical. Two funds tracking different indexes, or an index fund and an actively managed fund in the same asset class, should not be substantially identical, though there is no definitive IRS ruling. Vanguard's article on tax loss harvesting suggests that the risk may also be higher with funds from the same provider, so that selling a Vanguard fund to buy a Vanguard fund tracking a similar index is more likely to be a wash sale than selling a Vanguard fund to buy a Fidelity fund tracking a similar index. However, Vanguard's recommendation of funds which its advisory service might recommend to avoid wash sales includes many similar Vanguard indexes.

Therefore, when tax loss harvesting, if you do not put the proceeds of your sale in a money market fund for the 31-day waiting period, you will need to find a similar fund that does not qualify as substantially identical. It's important to switch into a fund that you are comfortable holding. If the market goes up after you tax loss harvest, you should plan to hold the new fund for a year in order to get the less costly long term capital gains tax treatment on your sale.

You can also reduce the risk of wash sales with your IRA by not holding substantially identical funds there and in your taxable account; if you have an S&P 500 index in your IRA, you can hold Vanguard Total Stock Market or Vanguard Large Cap Index instead of Vanguard 500 Index Fund in your taxable account.

Fund alternatives
The Vanguard Total Stock Market and Vanguard Large Cap Index track different indexes, but the returns are similar, and as such, they are good alternatives for domestic holdings. Vanguard Total International Stock Market and Vanguard FTSE All World Ex-US also have similar performance while tracking different indexes. Vanguard has a list which its advisory service may recommend. If you hold ETFs, iShares Dow Jones U.S. Index (IYY) is a good substitute for Vanguard Total Stock Market ETF (VTI), and SPDR MSCI ACWI ex-US (CWI) is a good substitute for Vanguard FTSE All-World ex-US ETF (VEU). Non-Vanguard ETFs have higher expense ratios and track different indexes than Vanguard ETFs, but their performance should be nearly identical to their Vanguard equivalents. There are bid/ask spreads and commissions associated with buying and selling ETFs, and those costs have to be considered when deciding on your short-term replacement holding.

Tax-exempt funds
Although not a wash sale, there is a special rule for tax exempt funds that have been held less than 6 months and which have distributed dividends, which acts like a wash sale, but can actually be more punitive: Fine points about tax loss harvesting.

Related party transactions
Although not a wash sale, related party transactions are similar in that a deduction for a loss can be permanently disallowed if the transaction occurs between related parties. 26 U.S. Code § 267 provides the official text for related party transactions. Publication 550 also provides details on related party transactions.

Relevant differences between wash sales and related party transactions are the following: "Indirect transactions. You cannot deduct your loss on the sale of stock through your broker if, under a prearranged plan, a related party buys the same stock you had owned. This does not apply to a trade between related parties through an exchange that is purely coincidental and is not prearranged." There is some debate about whether transactions involving a spouse should be a wash sale or a related party transaction. Spouses are not mentioned in the wash sale code (Section 1091), but they are in the related party transaction code (Section 267). Spouses (and corporations that the taxpayer controls) are listed in both the wash sale and related party transaction sections of IRS Publication 550. Section 267 states that the related party transaction rule does not apply if the loss is disallowed due to the wash sale rule.
 * 1) Replacement share purchases, which trigger a wash sale, are limited to a +-30 day window around the sale for a loss. There is no similar time window for related party transactions.
 * 2) If a wash sale occurs, the basis of the replacement shares is adjusted to account for the loss, unless the replacement shares are in a tax-advantaged account. There is no similar basis adjustment mechanism for related party transactions, although the related party can deduct the loss off any realized gains when those shares are subsequently sold.
 * 3) There is a coincidental transaction exception for related party transactions, which is not present for wash sales:

IRS source documents
From 26 U.S. Code § 1091:

"(a) DISALLOWANCE OF LOSS DEDUCTION In the case of any loss claimed to have been sustained from any sale or other disposition of shares of stock or securities where it appears that, within a period beginning 30 days before the date of such sale or disposition and ending 30 days after such date, the taxpayer has acquired (by purchase or by an exchange on which the entire amount of gain or loss was recognized by law), or has entered into a contract or option so to acquire, substantially identical stock or securities, then no deduction shall be allowed under section 165 unless the taxpayer is a dealer in stock or securities and the loss is sustained in a transaction made in the ordinary course of such business. For purposes of this section, the term “stock or securities” shall, except as provided in regulations, include contracts or options to acquire or sell stock or securities."

From IRS Revenue Ruling 2008-005:

"ISSUE

If an individual sells stock or securities for a loss and causes his or her individual retirement account or Roth IRA to purchase substantially identical stock or securities within 30 days before or after the sale, is the loss on the sale of the stock or securities disallowed?

...

HOLDING

The loss on the Sale of stock is disallowed under § 1091. A’s basis in the individual retirement account or Roth IRA is not increased by virtue of § 1091(d). This ruling does not address any issues other than those specifically addressed herein. In particular, this ruling does not address (and no inference should be drawn with respect to) any issue arising under § 4975."

Examples of 'substantially identical'
The following examples were pulled from a white paper from G2FinTech.

Substantially identical

 * Hanlin v Commissioner (1938, 1939) found the following pairs of bonds to be substantially identical, where the only difference between the bonds is as noted:
 * 1) City of Philadelphia bonds, issued in 1918, maturing in May and November, 1948.
 * 2) City of Philadelphia bonds, issued in 1919, maturing on March 1, 1949.


 * 1) Federal Land Bank of Omaha bonds maturing July 1, 1953, redeemable after July 1, 1933.
 * 2) Federal Land Bank of Omaha bonds maturing January 1, 1956, also redeemable after July 1, 1933.


 * IRS Revenue Ruling 1958-211 found the following bonds to be substantially identical:
 * 1) U.S. Treasury 2 1/4 percent coupon (bearer) bonds maturing December 15, 1962, but callable on and after December 15, 1959
 * 2) U.S. Treasury 2 1/4 percent registered bonds, maturing June 15, 1962, but callable on and after June 15, 1959

Not substantially identical

 * Hanlin v Commissioner (1938, 1939) also found the following bonds to be not substantially identical:
 * 1) Federal Land Bank of Louisville bonds maturing July 1, 1953, redeemable after July 1, 1933
 * 2) Federal Land Bank of St. Louis bonds maturing January 1, 1954, of which $10,000 par value were redeemable after July 1, 1934
 * 3) Federal Land Bank of Wichita bonds maturing January 1, 1954, and carrying no advance redemption date


 * IRS Revenue Ruling 1958-210 found the following bonds to be not substantially identical, where one of the bonds is redeemable for application to the taxpayer’s tax obligation due from a deceased owner’s estate and the other is not. Also, one bond is available for investment by commercial banks at the time the bonds were purchased and sold, and the other bond does not become so until 14 years later.:
 * 1) 2 1/2 percent treasury bonds maturing in September of 1972
 * 2) 2 1/2 percent treasury bonds maturing in December of 1972


 * IRS Revenue Ruling 1959-44 found that bonds from different local housing authorities, issued under agreement with the federal government, were determined to be not substantially identical, even though they were both backstopped by the federal government and would be substantially identical if issued by the same local housing authority.


 * IRS Revenue Ruling 1960-195 found the following bonds to be not substantially identical:
 * 1) Richmond-Petersburg Turnpike Authority 3.45 percent Revenue Bonds.
 * 2) Richmond-Petersburg Turnpike Authority 4.5 percent Revenue Bonds.


 * IRS Revenue Ruling 1976-346 found the following bonds to be not substantially identical:
 * 1) U.S. Treasury 63/8 (7 7/8) percent bonds maturing in 1982 and not redeemable at par.
 * 2) U.S. Treasury 41/4 (10 1/4) percent bonds maturing in 1992 and redeemable at par.