Now that the year is coming to a close, many investors are looking for ways to improve their tax efficiency. As you prepare your investment portfolio for year end, you might be thinking of selling, and locking in a capital loss. This can be a great way to offset some of your capital gains — and even some of your other income. However, you do need to be careful. Your brilliant tax strategy can backfire if you fall afoul of the IRS wash sale rule.
What is the Wash Sale Rule?
One of the tempting ideas that many investors have is this: Sell a stock, lock in the capital loss for tax purposes, and then turn around and buy that stock again at the low price. You’ve got a great deal, since the stock might run up again, and you’ve locked in losses. It seems like a great plan, but the IRS is already ahead of you. When you follow this path, it’s considered a wash sale.
The IRS wash sale rule stipulates that you can’t repurchase a “substantially identical” security within 30 days and be able to use the capital loss to your tax advantage. So, if you sell your stock for the loss, you won’t be able to use the loss to offset your capital gains and/or income if you repurchase within 30 days. Before you sell a stock, make sure that you are willing to wait the 30 day period before buying it again if you plan to use the loss to your advantage.
What Is a “Substantially Identical” Stock?
Obviously, you can’t repurchase the same investment if you don’t want to run afoul of the IRS wash sale rule. But what about other definitions of “substantially identical?” The IRS isn’t terribly forthcoming, but there are some things that you can keep in mind.
You can actually buy a new stock in the same sector. Just because you sold Coke doesn’t mean that you can’t buy Pepsi within the 30 day period. This is a strategy that some employ; they sell for a capital loss, and then buy something else in the same industry — something that is likely (but not guaranteed) to move in the same direction as the stock you just sold.
However, it is important to realize that you might not have the same luck if you decide to buy stock in a company that plans to buy the company whose stock you just sold. The IRS considers that if one company’s stock performance is linked in a direct way to another’s they are “substantially identical.” A merger between two companies means that the price of one is reflected in the price of another. For the IRS, that’s enough to be considered “substantially identical.” Buying the company could mean a wash sale in the eyes of the IRS.
Mutual funds are a bone of contention. However, to be on the safe side, my accountant recommends that you not purchase index funds pegged to the same index within 30 days after selling a loser. So, if you sold a loser pegged to the Russell 2000 from one broker, you might reconsider before going to a new broker and buying Russell 2000 at a bargain price. (It is worth noting that some think that a managed fund and an index fund would not be considered “substantially identical.”)
As you prepare to sell stocks at a loss, make sure you understand the wash sale rule — and make sure that you are prepared to avoid buying what you just sold for at least 30 days.