MMM-077: Less Rock, More Talk
Wish list for the iPod Touch. Beckham’s injury. Presidential Candidate sells stocks. Short-term investing. Stock history. Philosophy jokes. It takes two to do the tax-loss Tango. Our tool helps you figure out how much you’d have after 10 years by saving $60 per month and investing in the market.
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- Why didn’t the Presidential Candidate buy the Vanguard Total Stock Market Index for her portfolio?
- Sir Alex Ferguson says David Beckham won’t transform American soccer. I guess especially now that he is out for the rest of the season.
- Will Apple’s iPod Touch be able to hook up to Skype to make free calls? I’d also like to see a password locker application for it. Check out 1passwd.com if you use a Mac.
- The Barrons 400 index was recently announced. I’m not sure if I like it or not. They use a computer program to pick the 400 best US stocks out of the 5000 every six months. They say it has outperformed the Dow Jones, the S&P 500, and the Wilshire 5000. Yeah, but at what RISK? They will make their money off of licensing fees to ETF companies. Easy money!
- Our Tool helps me figure out how much I’ll have in 10 years after I switch to Verizon FiOS for TV and long distance.
- Mozzzie wants to know how to invest for the shorter term. RCS!
- A stock history lesson from Step 9. The CRSP database. Small value wins!
- It takes two to do the tax-loss Tango.
Music from music.podshow.com:
ALTA PLAZA – XRAY DOGS
Money – Theory in Motion
Black Coffee – Aramitsu
Runaway Train – Under Feather
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Thanks again for another great show. I’ve been listening since April 2007, and I always look forward to downloading the MMM podcast.
In show 77, you had a segment entitled the “Tax-Loss Tango.” In summary, you suggested that you could purchase two similar mutual funds (i.e. S&P 500 index funds) and transfer money between these funds in order to capture losses while at the same time avoiding the “Wash Sale” disallowance rules. I disagree with this conclusion.
The wash sale rules under section 1091 state that you have a wash sale if you sell stock (or fund) at a loss, and buy substantially identical securities within 30 days before or after the sale. The intent of this rule is to prevent investors from recognizing losses when his or her respective economic position has not changed. The operative term in the wash sale definition is “substantially similar.”
Consider the following example: Say you purchased 100 shares of the Vanguard 500 fund. The market takes a tumble, and your position depreciates by $1,000. On April 1, you sell your 100 shares at a $1,000 loss. You subsequently decide that’s a foolish move and you repurchase these shares on April 21. You hold these shares for the rest of the taxable year.
For income tax purposes, you may not recognize the $1,000 loss due to the wash sale disallowance rules previously mentioned since your economic position has not changed. You held 100 shares of the Vanguard 500 fund before the sale, and you held 100 shares of the Vanguard 500 fund within 30 days after the sale.
The issue is whether a similar index fund tracking the S&P 500 such as the RiverSource S&P 500 Index fund is substantially similar to the Vanguard 500 fund. Although reasonable minds can disagree on this issue, I feel as though an investors economic position hasn’t changed if he or she exchanges one S&P index fund for substantially similar index fund. You essentially own the same basket of securities before and after the transaction. That being said, this meets the definition of substantially similar, thus subjecting this transaction to the wash sale rules under section 1091.
Additionally, you can also have a wash sale if you sell one stock and repurchase a synthetic instrument in its place. For example, you own Apple stock and sell it for a loss. Within 30 days of that transaction, you purchase a total return swap with respect to future capital appreciation and depreciation dividends on this stock. Even though you don’t repurchase Apple stock specifically, you are in the same economic position as you were prior to the sale due since the replacement derivative instrument mirrors that activitiy of Apple stock. The IRS has ruled that synthetic securities, as described above are in fact substanially similar securities. Through swaps, options and futures contracts, all types of securities, including index mutual funds can be synthetically created through the use of derivative instruments. Therefore, the ticker symbol alone is not a good measure as to whether a security is substantially similar or not.
Keep up the great work, and once again, I thoroughly enjoy listening to the show.
-Mark in Minneapolis
Disclosure: I’m not a tax professional or with the IRS.
On tax loss tango. Gotta say Mark has a good point with something as specific as an S&P 500 fund because they must hold the same underlying securities by definition. Same is true about derivative instruments that amounts to the same thing.
But… moving from one small cap value ETF to another (or to a mutual fund) within the wash sale period seems ok. There is nothing “substantially identical” about these other than the overall fund objective. There may not even be one single underlying companies in common between them.
Is swapping funds only having a similar objective – ie maximize capital gains for example, enough to invoke wash sales rules? Hmmm, I doubt it. Would like to hear from a tax pro on this.
I did a search thru the Diehards forum for “wash sale” and came across an article that contained this link.
http://www.indexfunds.com/PFarticles/20000807_swap_iss_tax_RF.htm
and this link:
http://www.indexuniverse.com/index.php?option=com_content&view=article&Itemid=34&issue=21&id=2040
Both seem to say that swapping one SP500 for another hasn’t been shown to violate the substantially identical rule.
Have a read and lemme know if you agree or disagree.
PDB & VANCWA-
I think you both made good points. I’m a CPA that specializes in mutual fund taxation (not individual taxation), but I think I can weigh in on Van’s question. I agree with Van, and I don’t think that identical objectives (i.e. dividend maximization, long-term growth, Pacific Rim exposure), in itself, render two funds as being substantially similar. After all, Goldman Sachs and Bear Stearns have similar strategies, but there are no wash sale implications when one is sold for a loss and the other purchased within the 61 day window.
As mentioned in my previous comment, I believe it’s important to look at the underlying economic position. The following is an excerpt from a website that does a good job of articulating my argument –
http://www.fairmark.com/capgain/wash/wsident.htm
“The bottom line is that risk and the wash sale rule are tied together. If you have a strategy that completely eliminates risk from your sale and repurchase, it’s likely that you have a wash sale. You can’t report a loss for tax purposes without changing your investment position.”
While reasonable people can disagree on this issue (as authors of the articles in Paul’s links would disagree with me), S&P index funds own the same basket of securities. When you get into Large Cap, Small Cap, Mid Cap, International, etc. and closed-end funds, I think the issue becomes substantially more “gray,” as VAN points out. However, it seems as though when the economic position has not changed (as I argue with different S&P 500 index funds), the IRS in the past has generally disallowed accelerated deductions (i.e. wash sales).
I think it ultimately comes down to the taxpayer’s/practitioners judgment as the IRS has not provided clear guidance on this issue. I think the article PDB referenced highlights some good arguments for the non-wash sale treatment. However, I wish the author provided cites to the recent tax court cases he referenced as a part of his argument. I also noticed he runs a tax consulting practice for wealthy individuals, and he probably errors on the side of aggressiveness. I’m a CPA, so I naturally error on the side of conservatism. After all, if I don’t feel as though a tax position will have less than a 1 in 3 chance of surviving under an IRS audit, I won’t (and can’t) sign the tax return.
I think a taxpayer can avoid the issue completely by waiting until the 61 day period (30 days before and 30 days after the sale) before taking advantage of the tax loss harvesting. That’s the only way you’ll have a 100% certain tax position with respect to this issue!
Thanks again for your great show
-Mark
In response to the indexuniverse.com artcle, consider the parallels of the wash sale rules/logic to the tax straddle rules under 1092.
The tax straddle rules are extremely complex, but the basic idea is that if you have two offsetting positions, and sell one position for a loss, that loss must be deferred until the offsetting gain position is recognized (sold). For example, you buy 100 shares of Apple stock for $130. Additionally, you hedge your position and write a call option on 100 shares at $130. If the price increases to $150 your economic position hasn’t changed (excluding transaction costs). Your long position has increased in value by $20, and the written call option has declined in value by $20. In other words, you have a tax straddle.
Now pretend you own the Vanguard 500 Index fund. You hedge this position by entering into short S&P 500 futures contract. In other words, with a short S&P 500 futures contract, you are betting that the S&P 500 will decline in value. This once again is a tax straddle. If the S&P increases, your Vanguard 500 will increase in value and your short futures position will decline in value. The performance of the two positions offset each other. What if you held a different S&P 500 fund from a different fund complex such as a RiverSource S&P 500 Index fund? A tax straddle would certainly still exist if you entered into a short futures contract on the S&P 500. Since both positions result in similar treatment under the tax straddle rules, it would appear as though these positions are substantially similar in nature. It doesn’t matter if it’s a TRowePrice, Fidelity, Wells Fargo, or Vanguard fund: the answer is always the same in that you have a tax straddle. One long position in the S&P, and one short position in the S&P. By this logic, one must look at the underlying securities rather than the fund complex when determining the applicability of tax straddle rules.
The question is whether the logic discussed in the tax straddle rules can be applied to the wash sale rules. I think the underlying logic is applicable, but once again, reasonable minds could disagree.