Most investors are familiar with the concept of “capital gains.” A capital gain is a profit that results from the sale of an asset that has appreciated beyond its purchase price. While capital gains are taxable, long-term capital gains (those from investments held more than a year) are taxed at a favorable rate as compared to ordinary income.
What about capital losses?
While nobody wants to lose money, there are some advantages to booking an investment loss. In fact, capital losses can be used to offset capital gains from other investments or, if you you don’t have any (or enough) gains to offset, they can be used to reduce your ordinary income. While you’re limited to offsetting $3k/year of ordinary income, you can carry your losses forward until they’re used up.
Tax loss harvesting
This ability to offset gains and/or income with losses makes possible a strategy known as “tax loss harvesting.” Suppose you’ve invested in a certain mutual fund, and the price has tanked. Assuming that this is an investment you want to hold for the long term, you might be inclined to sit tight.
Instead, you might opt to sell your shares to book the loss so you can take advantage of your bad luck at tax time. Now that you’ve locked in your loss, however, you don’t want to miss out on a possible rally, do you? So the next question is… How soon can you buy back in? This is where the “wash sale” rule comes in.
What is a wash sale?
The wash sale rule requires that an investor wait at least 31 days after selling a security for a loss before repurchasing the same security, or a “substantially identical” investment. If you buy back in within 30 days, the IRS will treat it as if you never sold in the first place, and you’ll lose the ability to claim a loss.
Oh, and before you try to get clever, keep in mind that the IRS will also treat it as a wash sale if you make your purchase within the 30 days before the sale of your downtrodden shares. Thus, you can’t simply buy shares ahead of the sale to avoid triggering a wash sale.
What is “substantially identical”?
Unfortunately, the IRS hasn’t defined exactly what “substantially identical” means. The general consensus seems to be that, for example, a mutual fund and its corresponding ETF from the same company are likely to be viewed as substantially identical.
On the other hand, two funds tracking different indices (e.g., S&P 500) are unlikely to trigger a wash sale. The intermediate case, in which funds from different companies that track the same index are exchanged, is less clear. Experts are split, and the IRS hasn’t provided any guidance, but I wouldn’t risk it.
As always, be sure to check with a professional tax advisor if you’re unsure, as the stakes are often quite high in these sorts of transactions.