Illustration by Richard Cook
The boom years of the 1990s created a new class of tax-conscious investors. Various ways have been proposed to them to improve their after-tax returns. Some of these strategies reflect Constantinides' (1983) findings in a seminal article where he shows that it is optimal for investors to realize losses and defer gains through a procedure known as tax-loss harvesting.
While these tax strategies are theoretically appealing, they seem to be inconsistent with the behavior of many other investors who, as observed by Odean in a 1998 article, are unwilling to engage in tax-loss harvesting on the premise of loss aversion. Seemingly, these investors avoid selling their losing investments in the belief that they might bounce back. The same investors are also prone to do the opposite: Sell appreciated assets and incur tax costs.
This article is written for those investors who recognize that such investment behavior often proves to be quite costly. These investors, under the same circumstances, will opt instead for the potential benefits of tax-loss harvesting as a part of a broader portfolio management strategy.
Since an investor participating in tax-loss harvesting might easily run afoul of the IRS wash-sale rule, it is advisable to seek the critical tax-planning guidance of a CPA, who can explain the intricacies underlying such strategies. This is especially true when the financial product under consideration is relatively new. Indeed, much has been written about the wash-sale rule as it relates to stocks, bonds or even mutual funds; there are even landmark court rulings in these areas that supplement the existing tax code. For relatively new products such as exchange-traded funds (ETFs), howevers—which literally sprang to life in the early 1990s and only started experiencing success in the late 1990s—much remains to be demonstrated. Investors need information on how tax strategies apply to these products.
The primary goal of this article is to describe how ETFs can be used to minimize a portfolio's tax liabilities. By providing new opportunities to harvest losses, ETFs have basically presented investors with new twists on an old plot: how to take advantage of loopholes in the wash-sale rule without running afoul of it. This article also includes background information on ETFs and a review of the capital gains and losses as related to these products. This review will facilitate our understanding of how ETFs have been used so far in harvesting tax losses while steering clear of the Internal Revenue Service's (IRS) wash-sale rule.
Background Information On ETFs
Exchange-traded funds have been around since 1993, when the American Stock Exchange introduced the S&P 500 Depositary Receipts, known as the SPDR 500 or, more commonly, "Spiders." Spurred by a lot of enthusiasm, especially on the part of mutual fund investors peeking over the fence at this relatively new product, many more ETFs have been added since. According to statistics from Morgan Stanley, at the end of May 2004, there were 304 ETFs worldwide with assets of US$233 billion, managed by 35 managers on 28 exchanges around the world.
Trading throughout the day like stocks, these funds are baskets of securities designed to track an index of the broad stock or bond market, a stock industry sector or an international stock market. Devised in an investment environment ripe for innovation, ETFs have opened up new strategies ranging from asset allocation to tax strategies and hedging.
ETFs As A Pass-Through Entity
An ETF is comprised of either stocks or bonds. It may receive interest and/or dividends in cash. It may realize capital gains and/or capital losses, which may be short term or long term.
ETFs are classified as "regulated investment companies" by the IRS, and as a result, at least 95% of an ETF's interest income, dividends and capital gains must be passed through to the ETF shareholders. The tax characteristics, therefore, are determined at the shareholder level with the ETF acting like a tax pass-through entity.
So how is each shareholder taxed on these "passed through" gains and losses? First, it depends on whether the shareholder is an individual or a corporation.
In the case of an individual taxpayer, interest income and short-term capital gains currently are taxed as ordinary income, with marginal tax rates of up to 35%, while dividends and long-term capital gains are taxed only at a maximum rate of 15%. Typically, to be qualified for long-term treatment, a stock must be held for more than 12 months; otherwise, it is a short-term holding. With ETFs, however, the question of whether a holding is long or short term depends not on how long a shareholder has held the creation units of an ETF in his or her brokerage account, but on how long the ETF has held its underlying securities. (NOTE: This pertains only to passed-through taxes, not to the capital gains and losses associated with buying or selling shares of the ETF in your brokerage account.)
There are complicated rules in offsetting the passed-through gains and losses. In this circumstance the net short-term capital losses are used first, before the net long-term capital losses. If one is a gain and the other is a loss, they offset each other. As with all securities, net short- and long-term loses are deductible only up to $3,000 per year; additional losses are carried over to subsequent years.
Tax Swaps As Investment Strategy
Of the several techniques that seek to minimize taxes, tax swaps are one of the most common. A tax swap simply refers to a swap made to exploit some tax advantage. Its mechanics are fairly straightforward and involve few risks. Unlike the highly risky rate anticipation swap, it is not pegged to interest rate forecasting. Here, the investor simply seeks to simultaneously liquidate one position that has decreased in price, and replace it with a similar position if the ensuing realization of capital losses is beneficial for tax purposes.
The technique can be used whenever an investor has a substantial tax liability that has come about as a result of selling some security holding at a profit. The objective is to execute a swap so that the tax liability accompanying the capital gains can be eliminated or substantially reduced. The capital loss provisions in IRS sections 1211 and 1212(b) stipulate that investors may use capital losses to first offset up to $3,000 of ordinary income realized during the same year, with any excess loss carried forward to offset future income.
The loss will be disallowed, however, if the security purchased is "substantially identical" to the one sold (IRS section 1091). Investors who engage in such a transaction are suspected of seeking to harvest the loss for tax purposes without actually wanting to let go of the product. Simply put, if an investor, within 30 days before or after the day of the sale of a security at a loss, purchases a "substantially identical" security, the IRS will consider that investor as having broken the wash-sale rule and will disallow the tax loss. Hence, when investments are sold for a loss, "substantially identical" investments should not be bought within the wash-sale window, which is actually 61 calendar days: 30 days before the sale date (applied retroactively), 30 days after the sale, plus the date of the sale. This definition of the wash-sale rule is compatible with the definition from Barron's Dictionary of Finance and Investment Terms:
"Internal Revenue Service (IRS) rule stating that losses on a sale of stock may not be used as losses for tax purposes (that is, used to offset gains) if equivalent stock is purchased within 30 days before or 30 after the date of sale."
Because "substantially identical" might mean different things for different investments, the following is an overview of how the wash-sale rule applies to selected investment products.
The Wash-Sale Rule And Stocks
Consider this example: Investor purchased Pfizer for $70 a share and it is currently selling for $50. Its sale will result in a capital loss of $20/share. Can the investor sell the stock for the loss and immediately repurchase it for tax purposes? The answer is no. While the immediate purchase itself is not disallowed, the investor cannot take a tax loss on the sale. The IRS will consider the transaction a "wash." In fact, the wash-sale rule is broken even by purchasing a call option to acquire the same stock within the disallowed time period.
Of course, for investors who want to maintain a position in that same stock, the obvious option is to repurchase it after the 30-day limit expires, granted that the capital loss occurred in the same taxable year, if you want to take the loss for that tax year. The risk with this option, however, is the likelihood that the price of the stock may go up, forcing the investor to forego the capital gain, or that there may not be enough time left to implement such a technique and capture the loss in the current tax year, particularly at year-end. The second situation may not be of concern for those investors who may be better off taking a loss the year of the sale because they believe that they will be in a higher tax bracket the following year.
At this point, one might rightly observe that it's at year-end that these tax swaps become particularly popular among knowledgeable investors, when tax-loss sales and tax swaps multiply as investors hurry to establish capital losses. Under CPA and financial advisors tax planning guidance, this should not present a challenge.
While selling Pfizer and immediately repurchasing it is obviously a trade in "substantially identical securities," selling Pfizer and immediately buying a similar stock such as Merck is not, because the issuer is not the same. Although this transaction openly intends to "harvest" a loss for tax purposes, it is still allowed by the IRS even if the purchase of one stock (Merck) happens within 30 days of the sale of the other (Pfizer).
For those who prefer Pfizer over Merck based on the companies' fundamentals, they can always avoid the wash-sale rule using a practice known as "doubling up." As applied to our example, it consists of sitting on the unrealized losses while buying and holding an equal number of shares of Pfizer now (effectively doubling up.) Once the disallowed period has elapsed, investors can sell the original shares for a loss without violating the wash-sale rule because the purchase and sale are separated by the prescribed time.
The Wash-Sale Rule And Bonds
The wash-sale rule also applies to the sale of other financial instruments. In the case of bonds, tax swapping can be executed within the wash-sale window in the same fashion: selling an issue that has undergone a significant capital loss due to a deteriorating credit situation or an unexpected rise in interest rates, and simultaneously purchasing another with similar but not identical characteristics. While the term "substantially identical" has not been explicitly defined in this context, the characteristics of the purchased bond—starting with the issuer, the coupon rate, maturity date and call provision—will be thoroughly scrutinized by the IRS to determine whether the bond swap violates the wash-sale rule.
For example, an investor who holds a Pfizer 20-year, 5% bond that has undergone a substantial loss in value has the required tax shield in his portfolio as long as the same security is not purchased within 30 days of the date of the sale. Selling Pfizer 20-year, 5% bonds and purchasing Pfizer 4 3/4% bonds maturing, say, one year earlier, however, can be ambiguous: These bonds are so alike that they may be considered substantially similar. But an investor can purchase, within the wash-sale window, a comparable (in risk and maturity) 20-year, 5% bond trading at about the same price but issued by a different company. Indeed, securities are not considered "substantially identical" if they have different issuers or if they show substantial differences in either maturity or coupon rate, or preferably in both. If the bond purchased is from the same issuer, the remaining characteristics of the bond, such as coupon rate and maturity, should be different to avoid triggering the wash-sale rule.
The Wash-Sale Rule And Mutual Funds
Mutual funds are also subject to the wash-sale rule. As with stocks, redeeming a mutual fund and then purchasing the same fund within the 61-day window runs afoul of the wash-loss sale. But investors redeeming some of their shares in a mutual fund may violate the wash-sale rule without purchasing news shares, if the dividends from their existing holdings are reinvested by the fund within the wash-sale window. Keep in mind that reinvestment in dividends and capital gains are considered an acquisition.
For example, if investors sell shares in a fund for a loss on December 2 and the fund manager decides to distribute dividends on December 20, the 30 mandatory days have not elapsed. As a result, the loss sale will be disallowed by the wash-sale rule—or at least reduced by the number of shares purchased under the dividend reinvestment program. Obviously, this won't be a problem for those investors who prefer to accumulate dividends without selling shares in the fund. But for individuals who need to systematically withdraw cash from the fund, such as retirees, the possibility clearly exists that the wash-sale rule will disallow the tax benefits of selling shares at a loss.
The Wash-Sale Rule And ETFs
To illustrate, let us go back to our working example where an investor wants to sell off Pfizer for tax purposes. As noted, tax-loss harvesting is not allowed by the IRS section 1091 wash-sale rule if Pfizer is repurchased during the waiting period. But, because the stock has been subject to a buy recommendation from several equity analysts, our investor knows that he cannot wait 30 days from the day of the sale, or he may miss out on the rising stock price. Neither can he purchase a call option to acquire the same stock within the disallowed period, as he may violate the wash-sale rule. Fortunately, ETFs provide a number of possible strategies.
• Strategy 1: Harvest losses while maintaining exposure to the sector of choice.
Here is an example of how tax-loss harvesting using sector ETFs would work:
Suppose that our hypothetical investor still wants to maintain portfolio exposure to the pharmaceutical industry. As mentioned earlier, he may be able to counter the wash-sale rule by purchasing Merck, because that stock is not considered by the IRS as "substantially identical" to Pfizer, although its price tends to move in the same direction.
But although our investor is generally upbeat about the prospects of the broader pharmaceutical industry, let's say that he prefers Pfizer, and that he is not quite at ease with the favorable analyst advice regarding Merck.
Since Pfizer accounts for more than 19% of the Select Sector SPDR-Health Care-XLV (Table 1) ETF, an ETF that contains all of the health care companies listed in the S&P 500, this may help our hesitant investor from a few important perspectives. He can: (1) sell his Pfizer stock; (2) realize the loss for tax purposes; and (3) buy the Pfizer-heavy ETF to maintain exposure to Pfizer and to the health care sector in general. After the disallowed period has elapsed, he can sell the ETF and choose to buy back some or all of his Pfizer position. This is possible because sector ETFs are currently not recognized by the IRS as identical to the stocks that comprise their holdings.
Also, by effectively maintaining sector exposure during that period, he could effectively wait for a winner to emerge from within the sector. The equity analysts who were upbeat about Merck could be right after all. In the meantime, in addition to booking his tax losses while staying clear of the wash-sale rule, this investor has also reduced his risk by diversifying away from a single stock.
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Table 1: Select Sector SPDR Health Care (XLV) - Top 10 Holdings as of 03/31/04
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|
|
Company
|
Weight (%)
|
| Pfizer |
19.37
|
| Johnson & Johnson |
10.91
|
| Merck |
7.13
|
| Lilly Eli |
5.45
|
| Amgen |
5.44
|
| Medtronic |
4.22
|
| Abbott Labs |
3.95
|
| Wyeth |
3.64
|
| Bristol Myers Squibb |
3.43
|
| United Health Group |
2.95
|
|
66.49
|
|
| Source: American Stock Exchange | |
This strategy can be applied using any of the other sector ETFs. For example, underperforming technology stocks can also be sold for tax-loss harvesting purposes, with the proceeds reinvested in the SPDR Technology Fund (XLK), a technology ETF. This strategy will allow investors to remain marginally to significantly exposed to a specific stock, depending on its weight in the ETF, while waiting for the 30-day waiting period starting after the day of sale to expire. This tax-loss harvesting strategy is also considered safer than moving to a single, similar stock, such as Merck in our example, which could be affected by negative news.
Individual investors should also be aware that tax-loss harvesting using individual stocks can be a very expensive tax strategy. To be specific, harvesting strategies using stocks involve buying and selling these securities (round trips), and the commission costs may shave several percentage points off an investor's return, depending on how many trades are being executed. In contrast, under the guidance of CPAs and other tax advisors, loss harvesting strategies using sector ETFs rather than their component stocks can be much less costly to implement. Not only are the commissions smaller (a few cents a share), but they may also be negotiable.
• Strategy 2: Harvest losses from a mutual fund while maintaining exposure to the market through a broad-based ETF.
Exchange-traded funds also have started to be used by mutual fund investors seeking to turn losses into tax breaks. Suppose an investor owns shares of the Vanguard 500 Index Fund (VFINX) that have drastically dropped in value, as was the case in the early 2000s. (During the third quarter of 2002, most major market gauges such as the S&P 500 or the Dow Jones Industrial Average turned in their worst performance in decades.)
Of course, just as for stocks or bonds, if fund shares are sold to harvest the losses and then repurchased within 30 days starting after the day of the sale, the IRS wash-sale rule is clearly violated. This is especially true if dividends received are reinvested by the fund within the disallowed wash-sale period.
Similarly, just like as stocks, the obvious alternative is to wait out the wash-sale period. The disadvantage, of course, is that the value of the VFINX might go up in the meantime, depriving investors of potential capital gains. Larry Swedroe, principal in the firm of Buckingham Asset Management in St. Louis, recommends a more effective and increasingly popular strategy of reinvesting the proceeds from the sale of the VFINX in broad-based ETFs, such as the SPDR 500 (SPY). This way, tax losses can be harvested while maintaining exposure to the market.
Just like VFINX, SPY also represents a basket of stocks that fully replicate the S&P 500, widely recognized by asset managers as a gauge of the overall market. According to Morningstar (www.morningstar.com ), the coefficient of determination (R 2) with the S&P 500 for both VFINX and SPY is one. This means that all price movements in these two funds can be explained by activities in the underlying S&P 500. It also implies that the SPY will provide investors with the same exposure to the broad market as the VFINX. Since the IRS has yet to rule on whether such a transaction involving two different securities based on the same underlying index constitutes a wash-sale violation, this strategy using broad-based ETFs has—to date—helped investors harvest their losses for tax purposes.
From the IRS perspective, this is certainly a hard ruling to make, considering that the VFINX and the SPY are issued by two different companies, just as with debt or stock securities from Pfizer and Merck. They are also structured differently—the first is an open-ended mutual fund while the other is a unit investment trust. Also, whereas the VFINX is bought or sold only at the end of the day, the SPY trades continuously throughout the day, like a regular stock.
A caveat: Some experts warn against swapping for tax purposes funds and ETFs issued by the same company. For instance, an investor swapping the Vanguard Index Trust Total Stock Market Fund (VTSMX), a Vanguard mutual fund that seeks to replicate the Wilshire 5000, for the Vanguard Total Stock Market Vipers (VTI), an ETF that also tracks the Wilshire 5000 Total Market Index, could trigger the IRC section 1091 wash-sale rule because the two funds track the same index AND are managed by the same company.
• Strategy 3: Harvest losses from one broad market ETF while maintaining market exposure with another ETF.
Consider two ETFs: the S&P 500 SPDR (SPY) and the iShares S&P 500 (IVV). Undeniably, these two ETFs are similar in the sense that they both provide exposure to the S&P 500 and both trade on the AMEX like a regular stock. Whether this is enough to make them "substantially identical securities," however, remains to be demonstrated. Remember that this statement is ripe for interpretation, but also misuse. Although these two ETFs allow investors to maintain broad exposure to the market through the same index, they are nevertheless issued by two different management companies: The IVV is issued by Barclays Global Investors (BGI), while the SPY is issued by PDR Services LLC. Hence, just as Pfizer is not Merck, the SPY is not the IVV. (Morever, their structures are different. The SPY is structured as a unit investment trust while the IVV is an open-end fund, notwithstanding that the SPY's expense ratio is 0.10% whereas that of the IVV is slightly lower at 0.09%. )
Whether the swap of these two products for tax purposes is permissible under the wash-sale rule is a subject that is still under debate. Considering the lack of a concrete definition of the phrase "substantially identical securities" by the IRS in the case of ETFs, opinions widely diverge. There are certainly the cautious ones, such as Paul Mazzilli, an ETF strategist at Morgan Stanley who prefers to stay away from a tax swap involving these two ETF products simply because they track the same index. Others tend to be more aggressive. In their opinion, the nature of how ETFs are created precludes them from holding truly identical underlying securities. To these advisors, as long as investors don't buy the same exact ETF there is no reason to be concerned with the wash-sale rule. Under the strong belief that these two products are sufficiently different from each other and constitute securities that cannot possibly be considered "substantially identical," they will take the loss and then let case law decide. This strategy, of course, has its attendant risk.
Those who take a more dilettante approach to the problem believe that, even if the IRS eventually considers them to be considerably identical, in the absence of a previous ruling it may perhaps disallow such swaps moving forward but not penalize investors who have already engaged in them by adding the disallowed loss to the basis of the replacement shares.
Finally, with the increasing variety of ETFs coming to market, investors who truly are concerned about violating the wash-sale rule while harvesting their losses can maintain exposure to the market by purchasing shares in an ETF that tracks a different broad-based index, such as the Diamonds Trust Series 1 (DIA), an ETF that holds the stocks that comprise the Dow Jones Industrial Average (DJIA). The DJIA is another stock market average made up of 30 high-quality stocks believed to reflect overall market activity. In this case, the tax swap involves two ETFs issued by two different trustees and tracking distinctly different gauges of market activity.
• Strategy 4: Harvest losses from one sector ETF and replace it with a different ETF tracking the same sector.
To illustrate, let us assume that our hypothetical investor sells 200 shares of the iShares Dow Jones Technology index (IYW) at a loss. Repurchasing the same number of shares of IYW within the disallowed period for tax purposes will justifiably be disallowed by the IRS. Realized losses cannot be applied against the capital gains distributions our investor could receive without triggering the wash-sale rule.
However, the loss on the sale of the IYW could be claimed without violating the wash-sale rule if proceeds are used to buy shares in either the Select Sector SPDR Technology (XLK) or the Vanguard Information Technology VIPERS (VGT), two ETFs that also track the technology sector. Because these sector ETFs are issued by different management companies (BGI, State Street and Vanguard, respectively), and track indexes compiled by different providers, the violation of the wash-sale rule will be hard to validate.
In fact, many sector ETFs have equivalent ETFs that share similar investment characteristics, as shown in Table 2. We chose a sample of sector ETFs whose very names reveal their equivalency. Correlation analysis might yield others that produce similar returns. For example, a quick perusal of the holdings of Select SPDR Consumer Staples (XLP) and the iShares Dow Jones US Consumer Cyclical (IYC), two ETFs that are not included in Table 2, will show that the two sectors they represent are equivalent although their labeling is not. Because these ETFs use different industry classifications extra work needs to be done to establish any equivalency, but the ultimate reward is certainly worth the effort, considering the tax benefits. For example, both the SPDR and VIPER sector funds use the Global Industry Classification Standard, a classification jointly developed by Standard & Poor's and Morgan Stanley Capital International. The iShares sector funds currently use the Dow Jones Global Classification System and will soon switch to the Industry Classification System, jointly developed by Dow Jones Indexes and FTSE.
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Table 2: Sample of Sector ETFs with Similar Investment Characteristics
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|||
| ETF Name | Issuer | Equivalent | Issuer |
| Select SPDR Consumer Discretionary (XLY) | SSgA | Vanguard Consumer Discretionary VPERS (VCR) | Vanguard |
| Select SPDR Consumer Staples (XLP) | SSgA | Vanguard Consumer | Vanguard |
| Select SPDR Energy (XLE) | SSgA | iShare Dow Jones US | BGI |
| Select SPDR Financial (XLF) | SSgA | iShare Dow Jones US | BGI |
| Select SPDR Health Care (XLV) | SSgA | Vanguard Health Care VIPERS (VHT) | Vanguard |
| iShare Dow Jones US | BGI | ||
| Select SPDR Industrial (XLI) | SSgA | iShare Dow Jones US | BGI |
| Select SPDR Technology (XLI) | SSgA | Vanguard Information Technology VIPERS (VCT) | Vanguard |
| iShare Dow Jones US | BGI | ||
| StreetTRACKS Morgan Stanley Technology (MTS) | State Street | ||
| Select SPDR Utilities (XLU) | SSgA | Vanguard Utilities VIPERS (VPUT) | Vanguard |
| iShare Dow Jones US Utilities (IDU) | BGI | ||
| iShare Cohen & Steers Reality Majors (ICF) | BGI | StreetTRACKS Wilshire REIT (RWR) | State Street |
| Source: American Stock Exchange | |||
Continuing with the technology sector, the IYW can also be swapped for the QQQ, a broad-based ETF that tracks the Nasdaq 100 index. Because the QQQ is traditionally loaded with information and technology companies (Table 3), such a transaction could also represent a good tax strategy for an investor who wants to harvest tax losses in the technology sector and remain substantially committed to the sector (without violating the wash-sale rule).
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Table 3: Top Industry Sector of the QQQ and IWY as of 03/31/04
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|||
| Nasdaq-100 Index Tracking Stock | QQQ | iShares Dow Jones US Technology-IYW | |
| Industry | |||
| Information Technology | 60.43% | Software | 26.04% |
| Consumer Discretionary | 15.66% | Semiconductors | 25.95% |
| Health Care | 13.56% | Technology Hardware and Equipment | 23.69% |
| Industrials | 5.00% | Communications Technology | 20.34% |
| Telecomunication Services | 3.15% | Technology Services | 4% |
| Consumer Staples | 1.17% | ||
| Materials | 0.69% | ||
| Energy | 0.25% | ||
| Total | 100.00% | ||
| Source: American Stock Exchange | |||
A quick look at Table 3 clearly shows that the two ETF providers do not use the same industry classification. Yet, it remains clear that the QQQ is also heavily dominated by technology stocks: 63.58% of the fund is made up of Information Technology and Telecommunication Services equities. For those who are particularly wary of violating IRC section 1091, this transaction cannot possibly trigger the wash-sale rule, because the QQQ and IYW are unmistakably not "substantially identical obligations." In addition to being managed by two different trustees, the QQQ is classified as a broad-based ETF, as noted, whereas IYW is a sector ETF.
Do Stocks And ETFs Constitute "Substantially Identical Securities"?
Going forward, a question that will take on more and more relevance is this: Can a stock and ETF possibly be considered "substantially identical securities?"
According to IRC Section 1091(a), "In the case of any loss claimed to have been sustained from any sale or other disposition of shares of stock or securities where it appears that, within a period beginning 30 days before the date of such sale or disposition and ending 30 days after such date, the taxpayer has acquired … or has entered into a contract or option so to acquire, substantially identical stock or securities, then no deduction shall be allowed under section 165 … For the purposes of this section, the term 'stock or securities' shall … include contracts or options to acquire or sell stock or securities."
Although it may trade like a single stock, an ETF is legally a unit investment trust or an open-end mutual fund based on a basket of stocks. But for tax purposes, one must ask two questions: 1) Can a stock and an ETF be construed as substantially identical? 2) Is an ETF a contract or option to acquire a specific stock?
The answers are no for the former and yes for the latter (but only as part of a basket).
The IRS does not define the term "substantially identical." However, judicial and administrative rulings reveal some principles. For example, two bonds with two different rates issued by the same corporation are ruled not substantially identical. Nevertheless, two bonds with two different maturity dates issued by the same corporation are considered to be substantially identical. Preferred stock and common stock from the same corporation are not treated as substantially identical (USTC #9783), and two common stocks issued by two separate corporations are definitely not substantially identical. These examples indicate the principle that as long as the two securities are issued by two different corporations, regardless of what they represent, they are not substantially identical. ETFs are issued by financial institutions such as State Street, Vanguard, Barclays Global Investors, etc. For this reason alone, one would think they cannot be considered "substantially identical securities" as stocks.
With respect to the question as to whether an ETF constitutes a "contract or option to acquire a stock," if the answer is yes, then there is a connection between the stock sold to harvest the losses and the ETF purchased within the disallowed period. In order to circumvent the rule of wash-sale, our investor targets ETFs that must contain, among other stocks, a specifically desired stock. For example, Pfizer common stock accounts for 19.37% of the Select Sector SPDR Health Care (XLV). If an investor sells Pfizer stock and uses the proceeds to purchase XLV, this transaction could be interpreted as a "contract" to repurchase 19.37% of Pfizer back. From this perspective, although Pfizer and XLV are not exactly and "substantially identical," they are at least "19.37% identical." It's possible that our investor will then be denied only 19.37% of the loss, while the remaining 80.63% of the loss is recognized [Code Section 1091(b)].
It now can be seen that an ETF is such a hybrid product that it does not meet the requirement of "substantially identical," but it does constitute a contract to acquire a stock. In this conflict, the IRS could treat an ETF as a "partially identical" security in which only the buy-back portion of the loss would be denied.
Conclusion
Experts are still arguing whether trading ETFs managed by two different trustees are sufficiently distinct to stay clear of the wash-sale rule. While the term "substantially identical" has yet to be explicitly defined in the context of these relatively new investment products, the basic principle is that the individual cannot purchase "substantially identical" securities within the 30 days before or after a sale without violating IRC section 1091.
Using this principle as a basis for our article, we have described four ETF-based strategies that can be used by investors to reduce or eliminate the capital gains that they would otherwise pay on other profitable transactions in the current tax year. These strategies represent an improvement over tax swaps using traditional investments such as stocks or mutual funds. Simply put, tax swapping using ETFs enhances the ability of investors to convert unrealized losses into real losses that can be used to offset taxable gain without violating the wash-sale rule.
If an ETF also is considered a contract to purchase an underlying basket of stocks, this may make the ETF partially identical to the stock or stocks sold, providing those stocks make up part of the ETF. The losses on the component stocks that would have violated the wash-sale rule otherwise could very well be disallowed. On the other hand, since in that basket of stocks representing the ETF only the losses corresponding to the stocks deemed identical to the securities sold are disallowed, ETFs still present tax benefits over individual stocks even under this extreme but likely scenario.
Bibliography
Constantinides, G., 1983, "Capital Market Equilibrium with Personal Taxes," Econometrica, 51, 611-636.
Morgan Stanley, Exchange Traded Funds - Global Summary, May 31, 2004
Odean, T., 1998, "Are Investors Reluctant to Realize Their Losses," Journal of Finance, 53, 1775-1798.
