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How to Effectively Harvest Tax Losses

Use a proxy to stay in the market during the 30-day wash-sale period.

Helen Modly, 08/30/2007

The recent downward volatility of the market has a silver lining for many investors. Granted, their portfolio values are down from the lofty levels of a few months ago, but many now have tax losses that can be used to offset gains. The trick is to take these losses without upsetting the overall asset allocation of the portfolio.

What is harvesting of tax losses?

Good advisors are always looking for ways to reduce the taxable income our clients must realize from their portfolios. Of course, that doesn't mean we actually try to lose their money, but from time to time, there will be paper losses in a portfolio. Deliberately realizing these paper losses for tax purposes is what  harvesting losses is all about. It sounds simple enough. Just sell the position and realize the loss, then buy it back.

The Wash Sale Gotcha
If you do sell the security for a tax loss and plan to buy it back, be aware of the wash sale rule. This tax rule states that a taxpayer cannot claim a loss on the sale of a security if a substantially identical security was purchased within 30 days of the sale date, either before or after the sale. This includes shares that were purchased as part of an employer stock purchase plan or the exercise of qualified or non-qualified employer stock options. The rule requires the taxpayer to match shares so if 500 shares were sold at a loss and 100 shares were repurchased within 30 days, only the loss on 400 shares would be allowed.

The wash sale rule applies to all securities in any account registered to the same Social Security numbers as the taxpayer(s). So a sale of shares of stock ABC in a husband's individual account should be paired with the purchase of the same stock in their joint account. However, many CPAs never catch these wash sales that occur between accounts, especially if they are held by different custodians, because they do not actually compare the transactions on the 1099s line by line.

Another issue is the term "substantially identical security." Most advisors would agree that one custodian's S&P 500 Index fund is substantially identical to another custodian's S&P 500 Index fund. Since they have different fund names and ticker symbols, a wash sale between the two would also probably go unnoticed in most cases. This doesn't mean that it is correct not to report it, but many investors (and their tax preparers) just don't catch all these wash transactions at tax time.

The Risk of Being Out of the Market
Selling the security, waiting 31 days, and then buying it back will meet the wash sale rules, so what's the problem? Unfortunately, that means you no longer have the market exposure of that position in your portfolio. Most advisors are loathe to be out of the market in a security that they want in the portfolio, just to realize a tax loss. It may be that they think the particular security will rebound quickly or that the security represents a desired allocation to a particular asset class or industry sector.

In my experience, the law of "no good deed ever goes unpunished" dictates that the security in question will invariable experience a remarkable rise in value during the period you are out of the market. While you may save your client some tax dollars, you could cost them the appreciation lost while sitting out for the wash sale period.

Use a Proxy
The easiest technique is to use a different security as a proxy for the security you want to sell. For example, if there is a loss in your position of General Motors, you might sell those shares while buying shares of Ford or Toyota. Most advisors who pick individual stocks will object to the premise that one stock is interchangeable for another, but if a suitable replacement exists, this works well.

A more palatable option would be to use an exchange-traded fund as the proxy for your original position. If the position is an individual stock, select an ETF that holds a large percentage of that stock.

Large-cap stocks that are leaders in specific market sectors are the easiest to replace with an ETF. For example, to harvest a lost in Pfizer, there are ETFs that own Pfizer in differing percentages ranging from 2% to over 50%. Start looking at the ETFs that track very narrow pharmaceutical sectors to find the best fit. Since these ETFs are not considered substantially identical to a single stock, these transactions could be placed on the same day to settle simultaneously, thus avoiding any time out of the market. The trades could be flipped in 31 days, but many advisors would prefer to keep the more diversified exposure of the ETF in their portfolios.

What about losses in mutual fund positions? For any given mutual fund, there is an index that will correlate to the holdings of that fund sufficiently to use as a proxy for 30 days. The most likely candidate will be the index that the fund uses for its own benchmark. Select an ETF tracking that index.

Index mutual funds are even easier to replicate with an ETF, but there is some murkiness regarding whether the IRS would consider an S&P 500 ETF to be a substantially identical security to an S&P 500 mutual fund. One is a closed-ended unit investment trust, which trades as a share of stock and is priced throughout the day; the other is an open-ended mutual fund priced once daily after the market close. I have yet to meet the CPA who would identify this transaction as a wash sale. It doesn't even show up as a wash sale on the custodial tax report.

However, if you are concerned about the substantially identical issue, use a Russell 1000 ETF to serve as a proxy for an S&P 500 Index fund. The correlation between the two are almost identical. ETF Web sites have correlation calculators that will allow you to compare correlations between any ETF and various indexes, mutual funds, or individual stocks.

Substituting one ETF for another is the easiest proxy situation of all. All ETFs are designed to mirror a specific index or market sector. They differ as to sponsor, structure, and treatment of dividends. Most advisors feel these differences are sufficient to avoid the substantially identical issue. If this worries you, choose an ETF that corresponds to a slightly different index.

This strategy has its critics, but IRAs and 401(k) plans could be used to hold new shares of the security you want to realize the loss in, while you wait out the wash sale period in a taxable account. Some tax experts maintain that this is allowable due to the custodial registration of retirement plans and the fact that wash sale rules do not apply to retirement accounts. Other experts maintain that this technique runs afoul of related party sales. The IRS hasn't ruled one way or another on this subject, so inform your client of these issues before recommending this strategy.

Why Bother?
All advisors would like to tell their clients that there are no losses since every position has made money. But when losses do exist, don't waste them. We explain that harvesting losses throughout the year is our way of collecting "tax coupons" for them to use at the end of the year to offset other gains, and even up to $3,000 of ordinary income each year. The ability to carry losses forward makes them worth the few dollars in trading costs as long as you maintain your market exposure.

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