Wash Sale Question

[Elan]

I understand the basics of a wash sale. But I have a question on what's considered a "substantially identical security". Are ETF's that are similar in nature considered substantially identical? For instance, if I sold a Emerging Market ETF at a loss, and bought back a different Emerging Market ETF within 30 days, does that disqualify me from taking the loss for that tax year? I know I can defer the loss and "add" it to the basis of the new security, but I don't know that I want to do that. Is this the type of thing that anyone at the IRS checks or even cares about?

Jim

 

[Wonka]

EFT Wash Sale

Here's what I found in a brief research:

"The wash-sale tax rule prevents you from taking a tax deduction for a loss on a security if you buy that same security, or one that is substantially similar, within 30 days, either before or after the sale.

If you want to take a tax loss on a security, even an ETF, you may be able to do so and still avoid the wash-sale rule by either buying an ETF in the same sector as the stock you sold, or buying another ETF from a different company that covers the same market sector or the same index as the ETF you sold.

The IRS defines a substantially similar security as buying the same security, or buying a security that is convertible to the security, such as a call, or a convertible preferred stock or bond. So, a preferred stock is different from the common stock of the same company, but only if it cannot be converted to the common stock. So buying a different ETF that covers the same sector would seem to avoid the wash sale rule, because the ETF is not the same security as you had before, and it is not convertible to it. Likewise, you should be able to sell an ETF to take a tax loss, then buy a different ETF based on the same index, because the one ETF is not convertible to the other, even though they are both based on the same index. Ergo, in this scenario, it would seem, losses can be deducted on the sold ETF.

Because of the current popularity of ETFs, the IRS may change this rule soon, so definitely consult your tax advisor or attorney on this one".

I hope this is helpful.

 

[Elan]

Thanks for the reply. If it's strictly a matter of "convertibility" then it seems that most every ETF transaction is immune from the rules, which works for me.

 

[Wonka]

More info

For those reading this string wondering what the heck an ETF is, here's another article written by a FL tax attorney, Charles Rubin on July 12, 2006. It explains how they work, and answers your question as well.

I do want to caution you that the IRS might disagree, I haven't researched any tax cases on this subject. So, if there's a lot of money involved you may wish to confirm the correctness of both writings.

"USING ETF'S TO GET AROUND THE WASH-SALE RULE
If a taxpayer investor incurs capital gains in a year, typical tax planning involves also selling securities that are presently at a loss, to generate losses to offset gains and reduce taxes. After the loss property is sold, taxpayers often want to reacquire the property because they still consider it a good investment. However, Congress believes it is inappropriate to get a tax loss if you sell a security and then immediately buy it back. Thus, under the wash-sale rule, if an investor, within 30 days before or after the day of the sale of a security at a loss, purchases a "substantially identical" security, the loss on the sale is disallowed.

ETF's (exchange traded funds) are securities in an entity that owns a basket of stocks, such as stocks that make up a particular stock index or stocks of companies in a particular market sector. In a lot of ways they are similar to similarly structured mutual funds, except that the ETF's are traded directly on the stock exchange. The expanded use of ETF's provides some mechanisms for getting around the wash sale rules for investors in sector or index mutual funds. A recent article by Seddik Meziani and James G.S. Yang in the May 2005 issue of Practical Tax Strategies discusses some of these mechanisms and strategies:

a. Incurring mutual fund losses while maintaining market exposure through an ETF. If a taxpayer sells a loss position in a mutual fund, and then reacquires the mutual fund within the wash-sale period, the wash-sale rules will disallow the loss. If the taxpayer wants to continue the market exposure that was provided in the mutual fund, it should be able to buy an ETF with similar market coverage. Since the ETF will likely not be a "substantially identical" security to the mutual fund shares, this substitution of the mutual fund shares for shares of an ETF should not be subject to the wash-sales rules.

b. Incurring a sector ETF loss while maintaining market exposure to that sector. If a taxpayer sells a loss position in a market sector ETF, the taxpayer can maintain similar market exposure by acquiring directly several of the stocks in the sector that were owned in the ETF and that made up the largest positions in the ETF. While the taxpayer will still be less diversified in the sector than through the ETF, this should still allow for materially similar market exposure (at least until the wash-sale period expires and the ETF can be reacquired.

c. Swap one ETF for another. If a taxpayer sells a loss ETF, it may be able to find an ETF that is issued by a different company that has fairly similar market coverage. This should get the taxpayer around the wash-sale rule, although there is some uncertainty as how how different the ETFs need to be".