Turning Lemons into Cherries

January 01, 2003

Introduction

Losses in taxable mutual fund portfolios can be turned into a valuable asset. Realized losses can be used to offset realized capital gains from other investments during the year, and can be carried forward to offset future realized capital gains for as long as the investor lives. In addition, a small portion of the loss can be used to offset ordinary income in a current tax year and in future years. It is important for investors and investment advisors to harvest losses when able to take advantage of these tax savings.

One problem with taking a loss is that the position in the investment has been eliminated, thus the former owner does not have the benefit of a rally in the price of the fund after the sale or disposition. Popular studies of stock market performance have shown that by being out of the market on just a couple of good days can wipe out any advantage of being in stocks altogether. As a result, investors may wish to buy back shares as soon as possible to reestablish their position. But there is a problem. If replacement shares of a fund were bought within 30 calendar days after the date of a sale, or more shares were bought within 30 calendar days before the date of a sale, the Internal Revenue Service (IRS) would consider the transaction a 'wash sale' and the tax loss on the original shares would not be allowed. Replacement purchases have to be made outside of the 61-day restriction surrounding the sale date for the loss to be allowed. Repurchased shares are safe from the wash sale rule if they are on either side of the 30-day period.

Figure 1: Tax Wash Sale Rules

 

The wash sale rule applies when the securities sold and repurchased are the same issue or a 'substantially identical' security. The term substantially identical is defined under the Internal Revenue Code (IRC) § 1091 and appears in several tax court cases relating to stock and bond transactions; however, it is not clear how the term relates to mutual fund transactions. For instance, according to one Internal Revenue ruling, bonds issued by the same issuer with the same maturity and only a 0.55% difference in coupon payments were not considered substantially identical . Even though the total return of both bonds was practically identical, investment return was not a factor in that decision. In another ruling, agency bonds issued by different authorities with the same coupon, same maturity, and the same U.S. government backing were not considered substantially identical.2

As of this writing there have been no references in IRC regulations or the tax courts defining the term substantially identical as it relates to mutual funds. Nevertheless, extending current guidelines on other securities to the mutual fund marketplace does require a small leap of faith. One could argue that selling an S&P 500 index fund managed by one mutual fund company and simultaneously replacing it with another S&P 500 index fund managed by a second mutual fund company does not constitute a wash sale because different companies are sponsoring each of those funds. According to this author's interpretation of the tax code, as long as the two underlying issuers are not related, their funds are not substantially identical.

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