By: Investor Solutions, Inc.
Despite all the talk about dwindling portfolios over the past three years, one benefit of the bear market of the early 2000’s was the ability to take advantage of capital losses when selling your under performing mutual fund or stock holdings. However, one particular IRS Rule known as the “Wash-Sale Rule” will disallow a loss deduction when you recover your market position in a security within a short period of time before or after the sale. Under the Wash-Sale Rule, a loss deduction will be disallowed if within 30 days of the sale you buy substantially identical securities, or a put or call option on such securities.
The actual wash-sale period is 30 days before to 30 days after the date of the sale (61-day period). The end of a taxable year during the 61-day period still applies the wash-sale rule, and the loss will be denied. For example, selling a security on December 25th of 2003 and re-purchasing the same identical security on January 4 of 2004 will disallow a loss.
What are “Substantially Identical” Securities?
Buying and selling Dell stock is dealing in an identical security. However, selling Dell and buying Gateway stock is not dealing in substantially identical securities. The wash-sale rules do not apply if you buy bonds of the same company with different interest rates, buy bonds of different companies, or identical bonds outside of the wash-sale period. Pertaining to mutual funds, avoid buying back the same fund for 30 days; be cautious of investing from one S&P500 fund into another company’s S&P500 fund. Although I cannot find any cited wash sale violations for swapping S&P500 funds, I have encountered many tax professionals that would support the position of a wash sale.
So, if you own the Vanguard S&P 500 Index, you could hedge your position by selling your shares of the fund (realizing the loss), and immediately purchase another US Large Cap Growth mutual fund. This hedging technique keeps you fully invested in the market, and you still stay within the parameters of the wash-sale rule.
Let’s say you bought 500 shares of McDonalds on December 15, 2003. Then, on December 30, 2003, you sell 250 shares at a loss. This loss is allowed and not affected by the wash-sale rule. The wash sale would only be disallowed if you were to repurchase the 250 shares of McDonalds within 30 days after the sale. A bona fide sale made to reduce your market position will not trigger a wash-sale violation.
Many clients have asked me “If I sell my stock or mutual fund at a loss in my taxable account, can I buy it back immediately in my IRA?” The answer here is NO. There is much confusion with this rule, even among tax professionals. According to the IRS, you lose the deduction if you purchase the shares back with the 30-day period. You can also lose the deduction if you buy shares back through a related person, say your spouse’s brokerage account. The tax law has special language that includes “related persons”; this also applies to corporations, trusts, and partnerships. Common sense will tell you, if it seems too good to be true, it probably is.
So, now that you know the rules for tax loss harvesting, what are the annual deduction limits? There is no limit on the amount of capital losses that can be offset against capital gains. Currently, a net loss of up to $3,000 can be deducted from ordinary income each tax year. If you want to realize gains & losses on publicly traded securities, you have until December 31 of the current tax year to sell the security. In many cases, financial planners will scour through clients taxable accounts at year-end to find loss positions that can be used to offset taxable capital gains and generate the taxable loss.
Exactly How Does This Work?
First, short-term (1-year or less) gains and losses are netted against each other for the tax year, next long-term gains and losses are netted, and finally the outcome is combined together. Short-term losses are always deducted first followed by net long-term losses. If the net loss for the year exceeds $3,000, the excess loss may be carried forward into future tax years. The loss will retain its integrity as either a short or long-term loss.
Here are some planning tips that can be used while meeting the requirements of the wash-sale rule and improving your position for tax-loss harvesting:
- If you believe the security price is going to rise, but not immediately, you can sell now, realize your loss, wait the 31 days, and then recover your position by repurchasing before the expected rise.
- You can Hedge your current position by repurchasing similar securities immediately after the sale provided they are not substantially identical.
- Net Losses over $3,000 may be carried over into future years.
- If you and your spouse file separate returns, the capital loss maximum is $1,500, not $3,000.
- If an individual dies, his or her individual losses may not be carried over by the surviving spouse.
Now that you are familiar with the laws pertaining to the wash-sale rule and tax-loss harvesting, you’re armed and ready with the knowledge to apply portfolio losses against your capital gains. Remember, it’s never too early to start thinking about tax preparation. Consult with your financial advisor or accountant periodically throughout the year for advice on portfolio adjustments that might help you save money come tax time