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Tax-Loss Harvesting Time, EOY 2021 Tips & Wash Sale Dodging
🕑 Added 2021-10-26 08:13:49 +0000 UTCIt's the end of October, so it is time to start considering which losing positions we want to close for the tax deduction.
Tax rates on your gains can range from 0% long-term capital gains in a low income earner's account, all the way up to 37% for the highest earners. Since 2021 has been a great year for stocks, I assume that most of us are facing capital gains tax (if you're red for the year, buy more SPY).
As we all know, we can deduct our losses from our gains to reduce how much tax we owe. For example, if we have $10,000 in capital gains and $7,000 in losses, we only have to pay taxes on the $3,000 difference.
Because of this, it is in our favor to close losing positions at the end of the year so as to reduce our tax burden. There is usually little sense holding a losing position through the end of the year when it could reduce your taxes.
I wrote about this extensively last year in a post called Making Lemonade. If you haven't read that one, I recommend you do so before this one. This post will assume you are familiar with the basics already. Namely, make sure you are familiar with wash sales.
As a reminder, the IRS describes the following as a wash sale:
- Buy substantially identical stock or securities
- Acquire substantially identical stock or securities in a fully taxable trade
- Acquire a contract or option to buy substantially identical stock or securities
This leaves some gray area. Let's talk about some things that are wash sales, might be wash sales, and are not wash sales. Remember, we want to avoid wash sales because we want our deduction this year.
Things that are wash sales
We want to avoid wash sales because they force us to delay writing off our loss until we eventually close our position completely for more than 31 days. Since we want to claim our losses now, avoid the following. Source Source
1) Buying replacement shares within 31 days: Obviously. We know that we cannot sell shares and then buy them back within 31 days. That would be a wash sale. However, some people don't realize that it is also a wash sale if you buy shares before you sell the original set.
If you have 100x shares of COIN already, buy 100x shares on December 1, and then sell the original set on December 15, then it is a wash sale.
2) Having your spouse buy the shares: Think you can sell your shares for a loss and then have your wife buy them in her account? The IRS has already addressed this. It would be a wash sale, regardless of whether you file jointly or separately. If your girlfriend whom you live with buys the shares, though, then you're in the clear. Make sure you bring this up when you dodge the marriage question.
3) Buying back shares in another account: If you sell shares for a loss in one account and then buy them back in another, then it is a wash sale. This also goes for selling in a non-retirement account and then buying in a retirement account, or buying in a corporate account you own.
Your brokers are not going to catch the situation above. They won't report the wash sale since they don't have visibility across accounts. It is your responsibility to report that wash sale when you file.
4) Buying a call to replace shares: The IRS describes the following as a wash sale:
- Acquire a contract or option to buy substantially identical stock or securities
I really hate this bullet because it implies that a 7-DTE call at the 0.09 delta is a replacement for a block of 100x shares. This makes no sense, but these are the rules. We cannot, if we do this by the letter of the law, buy any call within 31 days of selling our shares or it will be a wash sale. This rule presumably works the other way too, as in selling a call for a loss and then buying shares.
Some professionals agree with me, though, and believe this bullet should be taken less literally. This source describes how he believes only ITM calls should trigger wash sales. This is the spirit of the law, but not the letter of the law.
In any case, our brokers will not identify this. Reporting this activity as a wash sale is the investor's responsibility. Personally, if I am selling shares for a loss and then buying OTM calls, I am not going to report that as a wash sale. I may not be in compliance with the IRS, but the rules are a bit gray.
This bullet can also be exploited to make wash sales work in our favor, which we will discuss later.
5) Selling at the end of Dec and rebuying in the beginning of Jan: If you want to sell for a loss at the end of Dec to take the loss and then rebuy in the first day of Jan, you're out of luck. Although the tax year closes on New Year's Eve, tax reporting isn't due for a few months. You broker will issue a correction.
This maneuver would be a wash sale, and if you buy back your shares within the 31 day window, you still have to report it on the previous year's taxes.
Things that might be wash sales
Since the wash sale law is pretty vague, there is a lot of gray area. Depending on which tax advisor or financial manager you ask, some things may or may not be wash sales.
If you use any of these methods, all signs indicate that no one is going to come after you. However, it is up to you to determine if it is worth the potential scrutiny. For disclosure, I have done 2 of these methods and no one has come after me.
1) Selling a put to replace shares: Let's carefully read that 3rd bullet one more time:
- Acquire a contract or option to buy substantially identical stock or securities
A short put does not allow us to buy shares. So, if we sell our shares for a loss and then sell an ITM put with a very high delta, is it a wash sale?
A short put with a delta of 0.97 is a much better replacement for shares than a 0.09 delta call. Presumably, the ITM short put should be a wash sale, but this is not what the wash sale rules state. I have never used this method before, but it is something I would consider doing.
2) Replacing one class of shares for another: No phrase in the wash sale rules causes more confusion than "substantially identical." What does "substantially identical" mean? Again, the IRS has not clarified this.
Are GOOG and GOOGL substantially identical? GOOG and GOOGL have different voting rights and only GOOG is subject to buybacks. Are they different enough to not be subject to the wash sale rule if interchanged?
Cited examples of substantially identical positions are corporate actions. In other words, if a stock changes its ticker, issues a stock dividend, merges, splits, or spins-off, then the new stock is the same as the old one. For example, even though TSLA split its shares and issued new ones, the new post-split shares are substantially identical to the old ones. Source
Based on these examples, it appears that GOOG and GOOGL are not substantially identical. If you somehow managed to lose money on GOOG this year, you can sell the position and buy GOOGL without triggering a wash sale. I did this exact thing in 2018.
3) Trading one ETF for another of the same index: VOO and SPY both track the S&P500. There are other indexed ETFs that do the same for other indexes. Are these substantially identical securities? No one will argue that QQQ and SPY are the same, even though they are very similar, because they track difference indexes. But when you have a pair of ETFs that by design track the same index, are they substantially identical?
Depending on who you ask, you'll get different answers. Some wealth managers say going from VOO to SPY would trigger a wash sale. Others say it is fine and is a common practice. Fortunately, it appears that the IRS does not push back on someone swapping one ETF for another of the same design.
In practice, you can freely swap ETFs whenever you want to, as long as the ticker is different. I did this in 2018 with no problems. This might not be what the IRS had in mind when it wrote its tax law, but the organization appears to have no interest in raising it as an issue. Source
Things that are definitely not wash sales
If you want to play it safe, there are plenty of approaches to keeping basically the same position without risk of running afoul of IRS regulations.
1) Swapping to relatively similar ETFs: If swapping SPY to VOO is problematic for you because it would probably trigger a wash sale if the IRS updated their guidance, you can swap less similar ETFs. SPY and QQQ are obviously different, and sometimes they even more in different directions.
However, the top holdings are almost exactly the same. If you want to sell QQQ for a loss and buy SPY immediately, you're at no risk of a wash sale. While you wait your 31 days to reenter SPY, holding QQQ is very likely to give you the same results for that month.
2) Go from a stock to an ETF or vice-versa: You can of course sell your shares for a loss and buy an ETF that carries that stock while you wait 31 days. This works best when the stock is a heavy holding in a particular ETF. Source
For example, if you lost money on ALB this year somehow, you can sell it and buy LIT ETF. ALB is 10% of LIT, and the lithium industry tends to move together.
3) Buy shares and sell an ITM covered call 31 days before you sell: You might have 100x shares of a stock you want to sell for the tax write-off, but you don't want to be without the stock in your portfolio for 31 days while you wait for the wash sale window to close.
You can buy additional shares more than 31 days before selling your original lot and claim the tax write-off when you sell the original set later. However, you may not want to hold double your intended position for a month.
You can get around this problem by buying the additional shares as expected, but then selling a deep ITM covered call expiring more than 31 days out. If you buy 100x shares and sell a 0.95+ delta covered call, you are pretty close to holding that position in cash with near-zero delta. You'll also recover most of the cash you used to buy the shares.
That 31-day window will tick by while you hold your shares + ITM short call, allowing you to effectively hold the same 1.00 delta position as before despite now holding 200x shares. At expiration, you can take assignment and sell the original 100x share position that is at a loss, and then ride the new set of shares as intended.
4) Cryptocurrency: There are no wash sale rules on crypto. If you managed to lose money on crypto this year, you can sell for a loss and repurchase your exact position immediately. It will not be a wash sale. Source
Although this is indisputably the case right now, Congress might close this tax loophole soon. Let's go, Brandon!
Realistically, it probably should be closed. But for now, let's take advantage of it. Source
Ruthless Exploit
Ironically, there may be a way to exploit the wash sale loophole to our advantage. We can perform rigmarole to force the wash sale rule onto a short-term call position so that we can repurchase our shares sooner. Robert Gordon of Twenty-First Securities Corp explains in this source:
Step 1: Sell the shares for a loss.
Step 2: Buy a short-term call immediately. Buying this call will trigger the wash sale rule.
Step 3: Let the call expire, or sell it. The loss from the shares will be applied to this call, and now your wash sale is satisfied and closed.
Step 4: Repurchase the shares. This will not trigger a wash sale because the wash sale has already been applied to the call.
I am skeptical about this method because it is absolutely not what the IRS had in mind, and could lead to scrutiny if you are audited. Your broker will also not perform this automatically, and will likely apply the wash sale to your shares. This would require you to manually make the changes when you file.
If you want to use this method, I can all but guarantee no one will stop you. Just keep in mind that if you're running for office, there might be a watchdog out there that comes after you. However, it appears that you are within the letter of the law if you do perform this maneuver.
I haven't done this method personally, but it is something that I keep in mind in case the situation arises.
Disclaimer: This article summarizes Mikey’s good faith assessment on Tax Loss Harvesting. However, Mikey is not a tax advisor and expects each reader to perform his own analysis, especially in an area as confusing as narrowly avoiding wash sale rules. When in doubt, consult a tax advisor.
