Many investors engage in tax-loss harvesting towards the end of the year. The crux of this exercise is to sell securities at a loss to offset taxes due on investment gains or other income items. Part of the harvesting process often involves replacing a sold security with a similar security, in an effort to maintain certain market exposures. However, that process can be intricate, and investors need to be sure they avoid a wash sale.
A wash sale is triggered when an investor sells or trades a security for a loss and, within a 30-day period before or after the sale, buys the same, or a substantially identical, security. There are many nuances to the wash sale rule, but the general purpose is to close a tax loophole in which investors try to avoid paying tax. Decades ago it was fairly easy to avoid wash sales by simply not repurchasing the same stock that you sold to realize the loss.
Ways to Trigger a Wash Sale
We know that selling one stock for a loss and buying a different stock would not present a problem because the securities are different. However, some investors may try to dance around the rules by repurchasing the same stock in a different account—perhaps in one's IRA. That move would trigger a wash sale. Similarly, an investor cannot sell a stock and then buy a call option on that same stock (which gives the investor the right to buy that stock at a future date). This is a roundabout way to gain exposure to the same security and would also trigger a wash sale. The same applies to trying to replace a security in the account of a spouse.
It should be noted that a loss that’s disallowed by a wash sale isn’t all bad news. That loss can be added to the basis of the replacement security. So when you eventually sell the new security, the disallowed loss would reduce your gain or increase your loss for that transaction.
Substantially Identical Assets
Nowadays, with the proliferation of mutual funds and ETFs, there is increased confusion about when a security or securities may be considered substantially identical, thus increasing the risk of an investor triggering a wash sale.
Michael Kitces recently wrote an article that tackles this complex issue for Financial Planning magazine. Specifically, he explores the lack of clarity surrounding when mutual funds and ETFs may be considered substantially identical. While it may seem like a given that actively managed mutual funds cannot be substantially identical because each fund is individually managed, a study of correlations tells a different story. Many large-cap growth funds, for example, are highly correlated, with many overlapping holdings.
The situation becomes even more confusing if we look at ETFs that track the S&P 500. With indexing methods rapidly evolving, 3 S&P 500 ETFs could all be fairly different if the first one weights the index by market cap, the second by some fundamental metric, and the third weights equally. Looking to the correlations of the funds and the number of overlapping holdings may provide the clearest indication of whether or not they could be considered substantially identical.
Clearly Avoiding a Wash Sale
The cleanest way to avoid a wash sale is to replace one stock with a different one. Or, if you really want to own that same security, stay organized with your dates and be sure that you don’t purchase that same security within 30 days before or after the sale.
Taking a tax loss is perfectly normal. But if you think you’ve found a way to beat the system by recreating a market exposure through a different account or makeup of securities, you could very well be triggering a wash sale. At a broader level, investors who maintain a diverse portfolio with a long time horizon may avoid many of these issues altogether by reducing their overall level of portfolio activity. If you do engage the tax harvesting process, it can't hurt to consult with a tax professional who can help to advise your specific situation.
 Kitces, Michael: Running Afoul of Wash Sales: Financial Planning Magazine: June, 2015