Wash Sale Rule Merely Delays Tax Loss

Your clients, like other taxpayers, hired you to help them keep money in their own pocket, rather than giving it to the IRS. In his second column on the subject, Julian Block discusses one way to do this -- wash sales -- in detail.

Oct 19th 2020
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A previous column discussed end-of-year strategies for investors, including a summary of the rules for wash sale. This column scrutinizes them in more detail.

Internal Revenue Code Section 1091 prohibits a tax deduction for a loss on the sale of stocks or other securities if an investor buys “substantially identical” stock within 30 days before or after the sale date. Section 1091 is subject to an important exception for an investor with a depressed portfolio.

While the often-misunderstood exception delays the deduction, it doesn’t permanently take away the deduction. What it does is allow investor Sadie to add the disallowed loss to the cost of her new stock for purposes of figuring gain or loss on a subsequent sale. When Sadie sells the new holding, the disallowed loss will decrease any profit or increase her loss at that time.

Section 1091 kicks in when, say, Sadie buys 100 shares of Legree Recreation for $10,000, later sells them for $8,000, and, within 30 days of the sale, acquires another 100 shares for $7,000. When she calculates gain or loss, the basis of the new shares becomes $9,000—the sum of the $7,000 cost and the $2,000 disallowed loss.

It’s possible for Sadie to unload the stock to nail down an immediate loss deduction for tax purposes and still maintain her position in an investment that she deems is a sound one for the long haul. There are two ways for her to accomplish that maneuver.

Option one: She’s always free to sell and let at least 31 days elapse before she repurchases. The obvious hitch, of course, is that the stock may increase in value during the waiting period. For 2020, her loss-registering sale can take place as late as the close of trading on the last business day—Thursday, Dec. 31.

Option two: She “doubles up,” that is, buys the same amount she already holds, waits at least 31 days, then sells the original shares.

Sadie’s risk: A loss that doubles if the stock declines while she sweats out the wait. Her benefit: A profit that doubles in the event that the stock price increases in the interim.

There’s still another way for her to accomplish her goal should she be willing to wait 31 days: Sell her stock and buy shares of a different company in the same or a similar industry. For instance, she might sell a bank stock and immediately buy the shares of another one. At the end of the year, investment advisors provide long lists of suitable switches.

The drawback to the sell-and-replace maneuver: She selects a substitute investment that may fail to perform as well as the original investment.

Question: I sold an S&P 500 index fund from one fund company to realize a loss and then immediately bought another S&P 500 index fund from a different group. Would the IRS consider this a wash sale because, in essence, they’d be identical?

Answer: Securities are deemed substantially identical if they aren’t substantially different in any material feature. Shares of two different funds aren’t substantially identical merely because both strive to emulate the same stock index, any more than two funds would be deemed substantially identical merely because both used the same investment strategy or tracked the same industry.

My advice: I’m on board with your switch. It’s an acceptable way to garner a capital loss and sidestep the wash sale rule. This holds true even if you switch to a similar fund in the same family.

Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 350 and counting). 

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