Wash Sales: How to Keep Your Tax Losses from Shrinking

Wash Sales: How to Keep Your Tax Losses from Shrinking

08/08/2018

When do taxes matter in investing? The short answer is always. After all, they can erode returns, and they pose a significant risk to high-net-worth and other tax-sensitive investors. So it’s vital for advisors to pay close attention to tax management at all stages of a portfolio’s life cycle.


Often this involves harvesting losses in the portfolio to offset gains—that is, selling a money-losing stock and then using the loss to reduce capital gains tax liability from any sales of appreciated stock. But what if the investor wants to harvest a loss but doesn’t want to lose the position in that particular equity holding? Can you sell a holding at a loss and then buy back that same stock shortly after to reestablish the position? Thanks to the IRS’s wash-sale rule, the answer is no.


What is a wash sale?

A wash sale occurs when an investor sells a security at a loss and then repurchases that security—or one that’s “substantially identical” to it, in the parlance of the IRS—within 30 days before or after the sale. In these situations the IRS requires investors to add the amount of the loss to the cost basis of their original holding, thus negating the loss’s tax benefit.


What’s more, it doesn’t matter whether the investor purchases stock in different lots. As long as the sale is within 30 days of any purchase, it could be considered a wash sale. Let’s look at a few wash-sale examples.


Example 1: Wash sale triggered by sale

 

Wash Sales

January 1: Buy 100 shares

of XYZ at $100 per share (Lot A)

Wash Sales

June 1: Buy 10 shares

of XYZ at $95 per share (Lot B)

Wash Sales

June 15: Sell 10 shares

of XYZ (Lot A) at $90 per share for a total loss of $100

 

Example 2: Wash sale triggered by purchase

 

Wash Sales

January 1: Buy 100 shares

of XYZ at $100 per share (Lot A)

Wash Sales

June 1: Sell 10 shares

of XYZ (Lot A) at $92 per share for a total loss of $80

Wash Sales

June 15: Buy 10 shares

of XYZ at $92 per share (Lot B)

 

Example 3: No wash sale triggered

 

Wash Sales

January 1: Buy 10 shares

of XYZ at $100 per share (Lot A)

Wash Sales

June 1: Sell 10 shares

of XYZ (Lot A) at $90 per share for a total loss of $100



In Example 1, even though the sale was from stock purchased in Lot A, which was bought more than 30 days ago, since it occurred within 30 days of the Lot B purchase, it triggered a wash sale. And in Example 2, even though the sale happened more than 30 days after the original purchase, the additional purchase 15 days after the sale also triggered a wash sale. In cases where there’s only one lot to sell, as in Example 3, the wash-sale rule doesn’t apply.


What happens when a wash sale is triggered?

The consequences of a wash sale can be administratively annoying, but they aren’t dire. If a trade triggers a wash sale, the IRS disallows the realized loss and the loss of the sold shares is transferred to the cost basis of the recently bought shares (known as “replacement shares”). So in Example 1 above, the $100 loss realized on June 15 is disallowed for reporting on the current-year tax return and $100 of cost basis is transferred to the replacement shares—which in this case are the 10 shares from Lot B purchased on June 1. Lot B sees its original cost basis of $950 (95 x 10) increase to $1,050 ($950 + 100). Similarly, in Example 2, Lot B’s cost basis rises from $920 to $1,020.


Can you avoid wash sales?

To an extent, yes. At Parametric, when we sell a security at a loss, we immediately purchase a set of similar securities that match the security we sold from a risk perspective. We also make sure we don’t buy back the same security within 30 days. Similarly, when we purchase securities we try not to sell those securities within 30 days.

That said, while we do what we can to avoid triggering wash sales, they can happen from time to time. For example, if we sell a security at a loss and a few days later the client instructs us to invest a large amount of money in the account, we may purchase shares of the recently sold security and trigger a wash sale. However, while the prior loss is disallowed, the cost basis of the replacement shares increases, which means there’s a reasonable chance we can help the client harvest a tax loss from it in the future.


The bottom line

The wash-sale rule is simply the IRS’s way of discouraging stock sales motivated primarily by tax reasons. Some investors resent it, some appreciate its intent, but regardless—it’s been part of the fabric of investing since 1954, when Congress passed the law, and it isn’t likely to disappear anytime soon.


It can be a tricky rule to navigate, but there are ways to work around it to help investors continue to harvest losses. Still, sometimes it’s hard to avoid triggering a wash sale and, depending on the situation, not always cost effective to do so. In consultation with the client, explaining the trade-offs is always helpful, whether they choose to avoid a wash sale or accept it with the knowledge that eventually it will all come out in the wash.

Potential Parametric Solution

One of the primary drivers of tax efficiency in a tax-managed Custom CoreTM account comes from tax-loss harvesting. Parametric portfolio managers will sell the majority of a basket of securities at a loss and simultaneously replace it with a different basket of purchased securities. The trade results in net tax losses for the client, which can offset capital gains realized by other parts of the portfolio, such as hedge funds.



Rey Santodomingo

Rey Santodomingo, CFA - Managing Director of Investment Strategy

Mr. Santodomingo is responsible for all aspects of Parametric’s Tax-Managed Equity Strategies. As one of the primary strategists for Custom Core™, he works closely with taxable clients and advisers to design, develop and implement custom portfolio solutions.


The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.

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