Wash Sale Rule
You need to be mindful of potential wash sales when implementing tax loss harvesting strategies. Be sure you are not selling out of and purchasing the same securities within 30 days of taking a loss. This goes for all of your accounts and your spouse’s accounts as well.
Review any model portfolios if you are making contributions on a regular business to make sure you are not accidentally triggering a wash sale. I have included the definition below.
Wash sale definition:
This is straight from the IRS publication 550:
You cannot deduct losses from sales or trades of stock or securities in a wash sale unless the loss was incurred in the ordinary course of your business as a dealer in stock or securities.
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 arrangement (IRA) or Roth IRA.
If you sell stock and your spouse or a corporation you control buys substantially identical stock, you also have a wash sale.
Substantially identical securities:
Tax loss harvesting can be put in jeopardy due to the wash sale rule. You need to be mindful when harvesting losses that you cannot buy a substantially identical security or fund. This is defined by the IRS and if it is violated you will be subject to the wash sale rules, where the loss will be disallowed.
Degrees of Risk:
There is not a lot of precedent regarding what is considered a substantially identical security in order to avoid the wash sale rule. It is straightforward in the sense that you cannot buy the exact same individual stock or fund with the same ticker. You can’t sell out of Tesla and buy it back, for instance. That is the same security, obviously.
The interpretation of the definition can get a little more complicated when you are trading mutual funds and exchange traded funds. This is because various fund companies can have similar investment objectives and the nature of these funds creates more grey area. You get into technicalities of how a fund implements trading, taxation, and market exposure.
The main consideration is to be aware of the wash sale rule when implementing these strategies. When considering a replacement fund you can look at the fund family or company, investment objective, active vs. passive, and taxation differences to determine the degree of risk should you be audited by the IRS.
Cost basis methods:
When considering making changes to your portfolio you need to understand your cost basis method when buying and selling securities. The most common methods are last in first out, first in first out, and high cost. These terms act similarly to how they sound. You can select your preferred cost basis method if you are using rebalancing or trading software. The software will then automatically propose trades based on your tax lot settings.
The custodian and fund companies keep track of your individual trade lots, or purchases, over time. If you are contributing money on a monthly basis you typically are buying into the same funds over time. This is where your cost basis method can become more important.
FIFO – First in first out or FIFO means that the first trade lots purchased will be sold. Under this scenario you are looking to sell your oldest shares. These are the shares you have held the longest. This means long term capital gains will be on your side due to the holding period most likely being longer.
LIFO – Last in first out of LIFO is when you are selling the trade lots that were bought most recently. This can be useful if you have shares that were purchased a long time ago and have appreciated significantly, as they could have been purchased at a lower price.
Highest Cost – The high cost method is when you are selling shares that have the highest price. This can help keep your capital gains lower since these will likely have appreciated less than shares held longer.
Lowest Cost – The low cost method if the opposite of the high cost method. The shares that were purchased at the lowest price will be sold. This means that the gains will be higher than shares purchased at a higher price.
Specific lot – You can also manually pick and choose which lots you would like to sell. There can be many variables to take into consideration so you may want to choose certain lots or investments depending on your situation.