After a year of wild stock market swings and declines, most federal employees have investment accounts that are sitting in the red, and while it’s difficult to watch your account value drop, many find a silver lining in the form of tax savings.
The tax strategy many federal employees utilize is tax loss harvesting, an effective strategy for building a bank of tax offsets. This strategy involves selling investments that have experienced a loss and reporting those losses when they file their tax return, allowing capital gains for the year to be offset dollar for dollar.
As effective as harvesting is, complications often arise when federal employees seeking to maintain the same mix of investments purchase a substantially identical security and accidentally trigger a wash sale, nullifying their losses.
So, for our fourth and final installment in our tax planning series, we’re going to review how federal employees can avoid a wash sale.
What Is a Wash Sale?
Before we cover how to avoid the rule, let’s ensure we have a good understanding of the wash sale.
As previously mentioned, one of the few benefits of owning an investment that has declined in value is that it can be sold and used to offset capital gains for the year. However, the IRS does not want investors claiming artificial losses for the sole purpose of offsetting gains; hence to that end, the wash sale rule was established.
The rule prevents investors (or their spouses) from recognizing a loss when they sell and repurchase the same investment, or a substantially identical one, within 30 days before or after the sale. The rule covers the sale of stocks, bonds, exchange-traded funds, mutual funds, and options sold in a taxable account (non-retirement account). Now let’s look at an example of a wash sale:
Example of a wash sale
Say five years ago, federal employee Bob purchased 20 shares of XYZ stock at $50 per share for a total investment of $1,000. Unfortunately, those shares have declined today to $10 per share, and Bob’s investment is now only worth $200.
In an effort to make the best of the situation and reduce his taxes for the year, Bob sells his 20 shares of XYZ and realizes a total loss of $800 that he plans on using to offset his capital gains for the year.
However, three weeks after selling his shares, Bob hears that XYZ has recovered most of its losses, so he repurchases 20 shares at $30 per share.
Now because the wash sale prohibits the purchase of the same investment, or a substantially identical one, within 30 days before or after the sale, this would be considered a wash sale, and Bob’s losses would be disallowed.
An important point to make here is that it would not make a difference whether Bob performed these transactions in one account or several because the wash-sale rule extends across all an investor’s accounts (including his spouse’s).
What Happens If You Make a Wash Sale?
So, what happens when a wash sale is triggered? As we saw in our example with federal employee Bob, when a wash sale occurs, the losses are disallowed and cannot be used to offset gains. However, the losses don’t disappear but are added to the cost basis of the new investment, as is the holding period.
For instance, if we continue with our example from above, Bob’s disallowed $800 loss would be added to the cost of the repurchased shares ($600 + $800 = $1,400), giving him a total cost basis of $1,400.
Thus, when the investment is finally sold without triggering a wash sale, any taxable gain will be smaller, and any loss will be larger.
How Can You Avoid the Wash Sale Rule?
Now that we understand what a wash sale is, how do we avoid it? Unfortunately, the IRS is a bit vague when describing what constitutes a substantially identical security, which, as you may have guessed, makes avoiding a wash sale a little tricky. That said, there are a few rules of thumb for avoiding a wash sale:
1) Stock of an Individual company is not considered substantially identical to the stock of a separate company, even if they operate in the same sector.
2) Swapping an individual stock for a mutual fund or ETF in the same sector will help maintain the portfolio’s market exposure while passing the smell test since these funds generally hold enough individual companies not to be considered substantially identical.
3) If replacing a mutual fund or ETF with a fund covering a completely different industry, tracking another benchmark, or replacing an actively managed fund with a passive fund (and vice versa), there should be no issues.
4) The surest way to avoid running afoul of the rule is to wait to buy the same or similar security for 30 days before and after the sale of the investment.
Harvesting losses is a great strategy for reducing taxes, but losses can be nullified if care isn’t taken to avoid a wash sale. So, in summary, to avoid this rule, don’t repurchase a substantially identical investment within 30 days before or after the date you sell a security at a loss.
While that may sound straightforward, the complexity lies in replacing your investment with something similar without it being substantially identical. The reason for this challenge is the IRS’s unclear definition of a “substantially identical” investment. That said, any one of the methods we reviewed can be used to avoid a wash sale.
Lastly, given the uncertainty, if you’re concerned about buying a potential replacement investment, consider consulting a fee-only Certified Financial Planner™ or tax advisor.
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2023 Legislative Change Notice
The SECURE ACT 2.0 passed and impacted many of the articles on this website. While the articles were correct when written, it’s impossible to re-write every article. Please consult a qualified professional (i.e., CFP®, CPA, or attorney) before implementing any strategy.