Tax planning and compliance for investors
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By Kaye A. Thomas
Updated June 1, 2007
You don't have a wash sale unless you buy substantially identical securities. Here's what that means.
The wash sale rule prevents you from deducting a loss on a sale of stock if you buy substantially identical securities within the wash sale period. (For an overview of this rule, see Wash Sales 101.) One way to avoid the wash sale rule is to buy stock that isn't substantially identical to the stock you sold.
As a general rule, stock of one issuer isn't substantially identical to stock of a different issuer, even if they are in the same industry. For example, Dell isn't substantially identical to HP. If you have a loss on one of these companies, you can buy the other one without having a wash sale.
This rule presents one of the most effective ways of dealing with the wash sale rule. If you want to report a loss but you're afraid the market will get away from you while you wait out the wash sale period, you can sell your losing shares and buy another stock that's likely to move in the same direction as the one you're holding. Of course, things don't always work that way: one company can have good news while the other has bad news. What you're doing is reducing the chance of missing an upswing in your stock's value, not eliminating that chance.
Suppose you own stock in a company that's about to be acquired by Bigco. Usually that means a boost in the stock price, but if you have a loss on your shares, the following plan may seem to make sense. Just before the merger you sell your stock and buy shares of Bigco — shares you would have received in the merger if you hadn't sold your original shares. That shouldn't be a wash sale because Bigco isn't substantially identical to the company you sold, right?
Wrong. The tax regulations say that if two different stocks are linked together in such a way that any change in the price of one will be reflected in the price of another, they're likely to be treated as substantially identical securities for purposes of the wash sale rule. If you use this maneuver, the wash sale rule disallows the loss.
There's some debate, but no direct authority, on the question of whether two mutual funds keying off the same index are substantially identical for purposes of the wash sale rule. Can you sell one S&P 500 index fund at a loss and buy a different S&P 500 fund the same day without having a wash sale?
Because there is no direct authority dealing with this question, reasonable minds may disagree. It's always possible to identify differences between funds managed by different companies, such as expense ratios and tax load. Some people conclude on this basis that funds maintained by two different companies are never substantially identical.
My feeling is that those differences aren't enough to prevent the two funds from being substantially identical. The point of the wash sale rule is to determine whether you've changed your position relative to the market. If you can lay the price graph for your new investment on top of the price graph for the old one and never see a significant disparity (as would be the case for two high quality S&P 500 funds), the investments should be considered substantially identical for purposes of the wash sale rule.
If I were sitting with a loss in an index fund and wanted to get around the wash sale rule, I would invest for 31 days in a high quality no-load managed fund that emphasizes stocks of the type that are in the index. A managed fund should not be considered substantially identical to an index fund (although even here the IRS could disagree). Yet a diversified holding of stocks that are in the same index should have a relatively small likelihood of diverging significantly from the index within 31 days. That's not to say there's zero likelihood of that happening. The mutual fund may have some heavy bets that go sour during that time. Bear in mind, though, that the reverse is equally likely: the managed fund may outperform the index for this period.
The bottom line is that risk and the wash sale rule are tied together. If you have a strategy that completely eliminates risk from your sale and repurchase, it's likely that you have a wash sale. You can't report a loss for tax purposes without changing your investment position.
The Treasury has yet to issue regulations or other guidance telling us when options will be considered "substantially identical." For further discussion, see Wash Sales and Options.
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