ETFs, Tax Losses and Wash Sales

Do you feel like getting a little more technical this week?  I am going to share a tip most people, even advisors, don’t know of.  It all revolves around ETFs, tax-loss harvesting and ETFs (Exchange Traded Funds).  Let’s begin at the beginning with a quick rundown of wash sale rules.

The wash sale rule was established by the IRS and basically says you cannot sell an investment holding, recognize the tax loss and then buy a “substantially identical” holding 30 days before or after the sale of that position where the loss is recognized.  Basically, if you have a loss on GE you cannot sell it and then buy it within 30 days on either side of the sale.  The IRS even looks beyond the individual.  So, it can consider the seller’s spouse and any entity the seller controls. Unfortunately, if I sold my GE stock at a loss my wife cannot buy it in her account within 30 days.  The penalty is you take the loss and add it to the purchase price of the new position to create your new cost basis.

Now, I love me some ETFs for various reasons.  First, you cannot beat their low cost.  Two, I would rather try and mirror the market than try and outperform it (odds are you will underperform it instead).  Finally, because there is a nice gap in there where ETFs are not considered “substantially identical” for wash sale rules.

A few years ago I learned a trick from an institutional money manager.  They had two lists of ETFs for their clients’ accounts.  I asked them why two lists and they explained it was so they could do tax loss harvesting, stay fully invested in the market and stay compliant with the wash sale rules.  My response was – Tell me more! 

Each list covered the main asset classes.  They covered large, mid, small companies, both value and growth.  The lists also included international, emerging markets, real estate, and all the major bond categories.  However, the difference between the two lists was the parent ETF company was different between the lists.  For example, maybe their A list had iShares for their large, mid and small ETFs.  However, on the B list of ETFs it may have been ETF providers such as Vanguard. 

They explained to me that while on the surface it would appear the two large-cap value ETFs were similar as they were covering the same underlying index, because the ETFs were from different companies they were not considered “substantially identical” per the IRS.  At least not yet.  Because of this fact they were running an extremely tax-efficient portfolio and constantly harvesting tax losses when the opportunities arose.  At the same time they did not have the worry of being out of the market waiting for the 30-day wash sale rule to expire.  This was pretty radical stuff I learned and something I have incorporated in my practice.

Now, is this something you can do on your own?  Yes.  Is it something you need to be very careful with so you don’t run afoul of the wash sale rules?  Absolutely.  You also need to stay on top of things because I have to believe at some point in time the IRS will declare ETFs substantially identical if they are covering the same asset category.  Additionally, I would recommend you are not doing too much tax-loss harvesting because trading costs may eat up your losses. 

You probably now know more about how you can use ETF’s for tax-loss harvesting and not violate the wash sale rules than 90% of advisors out there.  And I am not exaggerating with that number.  And remember, if you are going to follow this method, let’s be careful out there.