Wash sales are not the only hurdle to meet.
If you did your job last year, your clients should be sitting on significant tax losses to use in future years. You may not be thinking of harvesting additional losses now, but keep in mind that the wash-sale rules are not the only problem. You want to be aware of your holding periods if dividends are being declared during your trading window.
Advisors using mutual funds or exchange-traded funds are often diligent about harvesting tax losses using replacement funds as a proxy for the original holding. Though clients may have significant losses carrying over from last year's market meltdown, the objective of booking current losses for future use is still as valid as ever. President Obama's administration is talking about increasing the tax rates on capital gains up to 28% or more while holding the lower rate on qualified dividends. This would make it very important not to inadvertently lose the qualified status of a dividend payment while trying to harvest losses to offset future capital gains taxes.
Wash-Sale Rules: A Quick Review
Code Section 1091 disallows a tax loss to be claimed upon the sale of a stock or security when the purchase of a substantially identical stock or security is purchased within 30 days before or after the sale that resulted in the loss. Be sure to count calendar days, not business or trading days. There are actually 61 days to worry about: the day of the sale and the 30 days before and the 30 days after the day of the sale.
Under this section, actual shares of the substantially identical stock or security are matched to determine if any loss is allowed. For example, the taxpayer owns 100 shares of ABC stock that were purchased several years ago. They are trading at a loss so the taxpayer sells all 100 shares on March 1. Two weeks later, the taxpayer changes his mind and repurchases 50 shares of the same ABC stock. The loss on the sale of 50 shares will be allowed, but the loss on the other 50 shares is considered a "wash sale" and the loss will be disallowed because 50 shares were repurchased within 30 days. Disallowed losses are added to the basis of the security.
In the case where you bought 100 shares of ABC stock in January, and then two weeks later sold them for a loss, there is no wash sale as long as you did not buy replacement shares within the 61-day period. In this case the loss is allowed because no replacement shares were involved.
What Is Considered a Substantially Identical Security?
Actually, the IRS never defines this term. In most cases, tax preparers don't think the stock of one issuer is substantially identical to the stock of a different issuer except in the case of an announced merger or acquisition. So selling your shares of Exxon at a loss to buy shares of Mobil shouldn't be a problem. A big unresolved question is what about selling shares of mutual fund "A" that tracks the S&P index for a loss and buying shares of mutual fund "B" that also tracks the same index? Are shares of two different fund companies with the same investment objective substantially identical? What about replacing shares of an S&P index mutual fund with an exchange-traded fund that also tracks the S&P? In the real world, I doubt that these transactions are ever matched up to be wash sales.
Dividends: The Wrench in the Works
Dividends paid by domestic corporations as well as by many foreign corporations that are listed on U.S. exchanges, are eligible for favorable tax treatment if they meet the requirements to be considered a qualified dividend. Currently, qualified dividends are taxed at long-term capital gains rates, rather than as ordinary income. This can be especially important in tax years 2009 through 2010 because taxpayers in the 10 % and 15% marginal brackets have a 0% long-term capital gains tax rate, provided that their total income (including the qualified dividends and the capital gains) does not exceed these lowest brackets.
What's the Catch?
The 61-day time frame for wash sales is not the only time period to worry about. If a dividend was paid by the replacement security or fund, then a different holding period is required in order for the taxpayer to consider the dividend as qualified. The taxpayer must own the shares of the security or fund that paid the dividend for 61 calendar days in the 121-day period that runs from 60 days before the ex-dividend date through 60 days after. For some preferred stocks, the time frame is 90 days during a 181-day time frame.
Most advisors are focused on getting back into the original security or fund as quickly as possible after selling to realize a tax loss. If they overlook the dividend calendar when placing trades to harvest losses, they may inadvertently convert an otherwise qualified dividend into a nonqualified dividend. This scenario is most likely when advisors are attempting to harvest tax losses at the end of the year, when most mutual fund dividends are declared. For individual stocks, the dividend calendar varies, so some mechanism in your trade process needs to alert you to watch for dividends when selling shares.
A Perfect Storm
The worst possible case for advisors is the scenario in which a mutual fund dividend is paid during the 31-day period of holding the replacement shares, and the dividend is automatically reinvested by the fund, and the shares of the replacement fund are sold before the 61-day holding period for qualified dividends. Not only is the dividend converted to a nonqualified dividend for tax purposes, but the tax loss will be disallowed since the reinvestment of the dividend is considered to be a purchase under the 31-day wash-sale rules. To avoid this, don't wait until December to look for tax losses in mutual funds or plan to hold your replacement securities for more than two months.