Tax-Loss Harvesting Trickier In More-Volatile Times

December 10, 2008

 

Let's say you've got the SPDR S&P 500 ETF (AMEX: SPY). You sell it and buy the iShares S&P 500 Index (NYSE: IVV). They're essentially identical, which means you probably wouldn't get any tax benefits for substituting into that fund.

The rather vague IRS rule is that a substitute fund can't be "substantially identical" to the original holding. That's explained on page 55 of the wash-sales provisions in IRS Publication 550. You can find it here.

The official wording doesn't specifically talk about indexes. But the accepted rule of thumb, say advisors, is that the underlying benchmarks must be different to receive favorable tax treatment.

That means you should be able to swap SPY for the iShares Morningstar Large Cap Core Index (NYSE: JKD). That's what Chance Carson does for his clients at Alpine Strategies.

"It's correlated to the S&P 500, but it's a distinctly different index," said the Colorado Springs, Colo.-based advisor. "The one possible negative about JKD is it has much lower volume than SPY and a market cap of only $100 million. So it's not the type of investment someone with a larger portfolio would want to make."

Such liquidity concerns should only apply to investors with portfolios of $10 million or more, he added. As such, Carson says another more liquid choice to temporarily replace SPY might be the iShares Russell 1000 Index (NYSE Arca: IWB).

Another possibility is to stick your money into cash for 31 days. But that's not something Carson advises. "With the market as volatile as it is, that would represent the risk of missing out on a rally in a given asset class," said Carson. "You might wind up making a good market-timing call, but then you've really drifted away from being an asset allocator or a long-term risk manager of a diversified portfolio."

If possible, he advises investors to look for ETFs with average daily volumes of at least 100,000 shares per day. Carson also suggests that individuals delay making tax-loss harvesting moves until mid-December. That's due to the fact that a large number of institutions and hedge funds are wrapping up their tax-related swaps between mid-November and mid-December.

"We don't like to get caught in the extreme volatility of institutional funds and hedge funds selling. Generally, we've found that those sort of swaps die down by around Dec. 15 of each year," said Carson.

He emphasizes that investors need to check with their own tax experts before making any specific tax-loss harvesting changes. But Carson does offer the following list as possibilities for tax-loss harvesting within similar categories and ETFs he considers to show decent liquidity levels:

 

Category

Original

Possible Replacements

Large Blend

SPY

JKD, IWB, VV

Large Value

VTV

ELV, PWV

Large Growth

IWF

VUG, IVW

 

Category

Original

Possible Replacements

Small Blend

IWM

IJR, VB

Small Value

VBR

IWN, IJS

Small Growth

VBK

IJT, IWO

 

Category

Original

Possible Replacements

Foreign Large Cap

EFA

VEU, IOO

Foreign Small Cap

GWX

SCZ, DLS

Foreign Emerging

EEM

VWO, ADRE

 

 

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