Last (LAST!) Minute Tax Fix

December 30, 2005

Before you put the bubbly on ice, there’s still time to cut your tax bill with exchange-traded funds.


Ahh, the last trading day of the year… what a special time.  When else can you look at your portfolio and love your losers?  When else can you salvage (at least a moral) victory from the jaws of crushing defeat?  When else can you take money from the hungry jaws of Uncle Sam, simply by pushing a few buttons on the computer screen?

That's right … it's tax loss harvest time, when we sell the stinkers in our portfolios to keep the tax man from the door.  As readers of this page know, ETFs play an important roll in some tax loss harvesting strategies. So if you're looking for a way to cut your 2005 tax bill, and you've waited until the absolute last minute to do so, read on…

The Tax Swap

The basic principle of tax loss harvesting is simple: Sell your losers.  The IRS lets you offset any realized capital gains from this year with realized capital losses, so cashing out your losses can save you big on your tax bill.  Even if you haven't realized any capital gains this year, selling your losers can still make sense, because the IRS lets you offset up to $3,000 of ordinary income this year with capital losses.  Any excess loss can be carried forward into the future.

But wait, you say: I don't want to sell my losers.  I think the stock/sector/fund is due for a rebound, and I don't want to miss out.

That's where the "tax swap" comes in.  With the "tax swap," you replace the stock or fund you're selling with a similar stock or fund, thereby maintaining your desired exposure.  Notice the word "similar."  The IRS' "wash rule" prohibits you from taking a loss if you buy a "substantially identical" security within 30 days of the trade; that 30-day rule works on either side of the trade date.

There's a lot of debate about what "substantially identical" means, but the general outlines are clear. You can't sell a stock one day and then buy the exact same stock the next day; the IRS isn't stupid.  But you can, say, sell Coke and buy Pepsi, because those two companies are substantially different.

Investors are often reluctant to swap individual companies, however, because different companies can have vastly different CEOs, positions in a product cycle, or corporate risks.  Taking on a new company just for tax purposes exposes you to too many risks - what if the company issues a profit warning, or the accounting goes bad?

To get around these problems, investors are increasingly turning to ETFs.

Suppose, for instance, that you bought shares of General Electric in 2001, and are sitting on a nasty capital loss. You could sell your GE shares today, and swap that money into the Select Sector Industrials SPDR (XLI).  GE makes up nearly 22 percent of the XLI, and the two securities have been extremely closely correlated over the past few years, and no wonder:

Here's a look at a number of ETFs/stock pairs that fit nice into a tax swap strategy:



ETF Ticker



Merrill Lynch Biotech Holdrs




Merrill Lynch Broadband Holdrs




Merrill Lynch Telecom Holdrs




Select Sector Industrials




iShares Dow Jones US Energy




iShares Dow Jones US Consumer Goods




iShares Dow Jones US Consumer Goods




Select Sector Materials




Select Sector Technology




Select Sector Healthcare



Some of the percentages may not seem large, but in each case, the stock and the ETF correlate very closely - especially over the short-term.  Remember, after 30 days, you're free to sell the ETF and roll back into your chosen stock.  If you don't see your stock here, it's pretty easy to search around to find the right ETF to match your position - the Merrill Lynch Holdrs are a particularly rich source of concentrated stock positions.

As outlined in this comprehensive survey of tax lost harvesting strategies by A. Seddick Meziana (/JOI/index.php?id=513), there are other ways to use ETFs to harvest your losses.  For instance, you can swap out of a losing position in a given mutual fund or ETF and into a similar fund or ETF - say, swapping out of the Vanguard 500 Index Fund (VFINX) and into the SPDR ETF (SPY).  Both positions provide exposure to the S&P 500, but they use different vehicles, so they qualify as different under the wash sale rule.  Given the diversity of funds and ETFs available today, this ability to swap similar funds exists on the broad market, sector, style and country-tracking level.

What are you waiting for?  The clock's ticking...

Find your next ETF

Reset All