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ETF - Tax Loophole FAQ

Updated: Nov 22, 2020

How asset managers pay virtually no tax on gains


Have you ever wondered why high-net-worth asset managers pay virtually no tax on investment gains? The answer is Exchange Traded Fund (ETF), which is wildly used (some might argue “abused”) to sidestep wash-sale rules.


If Leo Tolstoy was alive today he would amend his famous quote “the two most powerful warriors are patience and time” to include ETFs. Despite wash-sale restrictions, ETFs are unparalleled in tax loss harvesting options, at least while no direct authority exists on this topic. Every fight has rules, of course, but harvesting does not have many -


Q1. Why harvest in the first place? — Short-term gains are taxed at ordinary rates, reaching 22% tax rate as early as 40K for single and 80K for joint filers (2020). With the top rate set at 37% on the federal level, adding state taxes makes it a rather gloomy picture.


Tax loss harvesting has been prolifically used to offset short-term gains, but there is a caveat — you cannot purchase a substantially identical stock within 30 days. The IRS treats that as a “wash-sale” and disallows the realization of the loss — all your harvesting efforts will be null and avoid. And as you might have guessed, if it has a CUSIP number it is subject to wash-sale limitations (ETFs, options, mutual funds, etc.).


Q2: What is substantially identical security? The tax law does not define it, and while, it is clear that buying and selling the same security meets this definition, the rest is rather vague. From the dawn of financial times, ETFs have been dark horses of harvesting. One simply cannot help but appreciate the variety and grandeur of choices. The majority of well-known indexes have on average at least 5 ETFs to track them, indexes are offered by different brokers/companies and that adds another level of peacock variety, which makes possible manipulations on a cosmic scale.


Q3: Can I sell Schwab S&P 500 at a loss and buy a Vanguard S&P 500 within 30 days without wash sale classification? There is no IRS ruling on whether ETFs from two different companies that track the same index are considered substantially identical. While funds are keyed off on the same index many argue that they do maintain a rather distinct identity. Sited differences generally include different managers/expense rations/liquidity levels and a claim that although funds might be replicating the same underlying index they are highly likely to use a different methodology.


It does seem, however, to be a violation of the intent behind substantially identical. After all, the rule does not say precisely identical. So, while IRS ruling is absent on this one, some investors take a conservative approach and shy away from using such blatant replacements.


Q4: Brokers do not flag wash-sales unless they are within the same account, why exercise caution? Besides the fact that it is against the rules? — IRS audit. Wash-sales will be flagged, losses disallowed, and investor will be up for back taxes, penalties, and interest.


Q5: Do wash-sale rules apply to IRA or spousal accounts? Yes and yes. IRS revenue ruling 2008–5 (at last..) covered this ground thoroughly and unapologetically.


Q6: How to avoid triggering wash-sale rules, yet remain active in the market with comparable reach? Infinite possibilities, for instance, you can sell S&P 500 and purchase ETF that is tracking Russell 1000 Index or DJIA. If you wonder as to how substantially dissimilar are these Indexes from the wash-sale perspective: Russell tracks 1000 largest publicly-traded companies in the U.S, S&Ps tracks 500 and DJIA — 30. Such a variety of bandwidth on the number of companies seems rather distinct on all accounts.


Q7: Does wash-sale rule have December 31 cutoff? — No. If you are planning to sell ETF or any other security at a loss on December 30th (to offset 2020 gain) and then purchase it again on January 10, 2021 — it is a wash-sale.


Harvesting ETFs is safe and more effective since investors can offset gains with no danger of crossing into a substantially identical zone, all the while maintaining their interests in a particular market segment. ETFs also add to their tax efficiency with infrequent capital distributions and proudly boast lower expense ratios. In the day and age of algorithmic trading, robo-advisors are capable of exquisite harvesting, but even a newborn investor can perform harvesting miracles. Survey your portfolio, harvest, offset — enjoy.


#Livewellandsave #Mytaxgoal


Sources: IRS revenue ruling 2008–5, Publication 550.


This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate for or applicable to specific circumstances. Consult a Certified Public Accountant before making any major financial decisions.

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