The Wash Sale Problem When Tax Loss Harvesting “Almost” Substantially Identical Mutual Funds And ETFs

Michael Kitces writes about the wash sale problem when harvesting tax losses in almost substantially identical mutual funds and ETFs.  His article begins as follows:

Harvesting capital losses to generate a current tax savings is popular. So popular, in fact, that not long after the US income tax was first created a century ago, the strategy was rapidly adopted as a tax savings technique and became a perceived tax abuse. In turn, this lead to the establishment of one of the first pieces of legislation to close an “abusive” tax loophole, and we now know Congress’ solution as the “wash sale” rules.

Yet the challenge of the wash sale rules is that the requirement not to own a “substantially identical” stock or bond within the 61-day wash sale period was rather straightforward to apply in its day, but has become outdated given the rise of pooled investment vehicles like mutual funds, and especially with the explosion of index ETFs. Now, taxpayers face oddly disparate treatment, where it’s not permitted to harvest the loss on a stock that’s down and replace with the same stock, but it’s “fine” to harvest the loss on a mutual fund that’s down and replace it with another mutual fund that owns overlapping securities.

Ultimately, the spirit of the wash sale rules was that investors should be required to endure some “tracking error” risk with the replacement security owned during the wash sale period… which means swapping ETFs with a 0.99+ correlation to harvest a loss without any risk of a performance difference almost certainly violates Congressional intent. And while it remains to be seen whether the IRS will become more aggressive in pursuing the issue, and/or whether Congress will attack this abusive “tax loophole” once again, the fact that there has been no action to limit the abuses yet does not protect taxpayers who are in clear violation of the spirit and intent of the rules in the first place. So investors should at least be cautious to consider how far they push the limits with tax loss harvesting of mutual funds and ETFs.

Read full article at: The Wash Sale Problem When Tax Loss Harvesting “Almost” Substantially Identical Mutual Funds And ETFs |

Posted by Lewis J. Saret, Co-General Editor, Wealth Strategies Journal.