When an investment underperforms, tax-loss harvesting is a way to offset the tax impact of capital gains while maintaining your preferred asset allocation. Some robo-advisors even automate this process. The IRS allows investors to use realized losses to offset gains and reduce their ordinary taxable income by up to $3,000 per year. However, the IRS may disallow some of those losses if they break the “wash-sale rule.”
What Is the Wash-Sale Rule?
The wash-sale rule attempts to prevent investors from snagging tax breaks unfairly. The rule says that investors cannot gain the short-term benefit of selling a security at a loss and then buy a substantially identical security within the next 30 days.
The “substantially identical” part of the rule is what often trips investors up. IRS Publication 550, which covers capital gains and losses, doesn’t offer a strict definition of what’s falls under this description. Rather, it states the following: “Ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation. However, they may be substantially identical in some cases.”
What the IRS is referring to here is when a company’s preferred stock shares certain characteristics with its common stock. For example, if the preferred stock and the common stock have the same voting rights or the preferred stock is convertible to common stock, then the IRS might consider them to be the same thing if you’re selling one to buy the other to harvest losses.
Additionally, you cannot avoid the wash-sale rule by, say, selling investments in your taxable brokerage account and repurchasing them in you or your spouse’s individual retirement account (IRA). If you’re within the 30 day-window and the IRS considers the new investment to be the same or substantially identical, it’s still categorized as a wash-sale transaction.
Examples of the Wash-Sale Rule
Let’s say you buy 200 shares of Disney stock for $15,000. As of May 6, those same 200 shares are now worth $12,000, leaving you with $3,000 in capital losses. If you then decide to repurchase those same shares on, say, May 15, you’ll violate the wash-sale rule. That’s because you bought the same stock within 30 days of selling it at a loss.
The wash-sale rule doesn’t just apply to individual stocks. It also covers exchange-traded funds (ETFs), mutual funds and stock options. This is where adhering to the rule becomes a little more challenging.
For example, say you buy an index fund that tracks the S&P 500, and that index subsequently sees a 5% decline in value. You know you want to stay invested in the market, but you’d also like to realize a tax benefit by selling the fund at a loss. That’s where tax-loss harvesting comes in: You could sell your fund and then immediately buy another S&P 500 index fund, allowing you to stay invested in the market while still claiming a loss on your taxes. However, the wash-sale rule would forbid this. If you want to swap it out for another index fund, you’d likely have to pick one that tracks a different index, such as the Russell 2000 or the Nasdaq Composite Index, to avoid triggering the wash-sale rule.
If you’re thinking of engaging in trades that could violate the wash-sale rule, it’s a good idea to work with a financial advisor who’s familiar with the rule.
Consequences for Violating the Wash-Sale Rule
Breaking the wash-sale rule, even if it’s not done intentionally, does carry a penalty. “Violating the wash-sale rule disallows you the tax benefit you receive from taking a tax loss,” said Westin McEntire, senior portfolio manager at Venturi Wealth Management in Austin, Texas.
You don’t miss out entirely, but it’s included in the cost basis of the new investment you buy. In other words, “The rule essentially cancels the benefit of taking the loss in the first place,” McEntire goes on to say.
The upside of this is that when you sell the replacement securities you bought, the disallowed loss would either reduce your gain or increase your loss on the sale. This essentially allows you to still reap the benefit of the harvested loss; you just do it later when you sell the replacement security.
How to Avoid the Wash-Sale Rule
Avoiding the wash-sale rule seems easy enough. For instance, if you sell a tech stock at a loss, replacing it with an ETF that tracks the tech sector as a whole may not raise any red flags with the IRS.
Of course, the best way to circumvent the wash-sale rule is to simply wait the 30 days out before buying again. “Track the trade date when a sale was made at a loss and set a calendar reminder to yourself 31 days out to alert you of the future date you can repurchase the original position,” McEntire says.
Robo-advisors and financial advisors can also help you navigate the wash-sale landscape. Robos often include wash-sale safeguards within their algorithms, and financial advisors likewise tend to know their way around the vagaries of the rule.
Because the wash-sale rule follows investors and not their individual accounts, a robo-advisor cannot keep an eye on what you do outside of your in-house accounts. That leaves you susceptible to the wash-sale rule if you make a trade on your own. Conversely, financial advisors usually have a better grip on your entire financial life and will theoretically be more wary of the wash-sale rule.
Ultimately, you have to use your best judgement when harvesting losses. The best thing you can do to avoid the wash-sale rule is pay attention to what you’re trading and when. It’s smart to try to get the tax benefit from harvesting losses, but make sure you’re staying in compliance with the law. It’s also make sure that in all that buying and selling, you don’t stray too far from your ideal allocation.
A financial advisor can walk you through when harvesting losses makes the most sense and how to choose replacement investments so you have minimal headaches at tax time. Your advisor will also be able to ensure that you’re keeping your overall asset allocation in line with your goals and risk tolerance.
Tips for Managing Your Investments
- Regulations like the wash-sale rule are just one reason why you might be better off working with a professional. If you don’t already work with a financial advisor, SmartAsset’s financial advisor matching tool can find you one today. Just answer some questions about your finances and investing goals, and the tool will match you with up to three fiduciary advisors in your area.
- Are you investing to achieve a specific financial goal? You may want to integrate financial planning into your money management repertoire. This will help ensure that you’re responsibly earning enough to reach your objectives.The good news is that many investment advisors also offer financial planning services, often for a fixed fee.
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