I like Zen thought. When I was a software developer, I used to say “the fastest way to write software, is not to write it.” That caused some puzzled looks until people realized that re-using something you’d already written is more efficient than writing something new. But this is a finance blog. How do you sell an investment without selling it? And, why the heck would you want to do that anyway?
Note: This post applies mostly to US investors since different countries have different tax laws.
OK I told a little white lie. My bad. You have to sell something. Otherwise you can’t take advantage of Tax Loss Harvesting and clearly there’s some selling involved with that. But it can be done in a way without any significant changes to your investments.
First though, a whirlwind tour of several hundred pages of tax code in 250 words.
Tax Loss Harvesting
When you sell an investment, you’ll either make money (Capital Gains) or lose money (a Capital Loss). In the US, you’re allowed to carry forward the amount of the Capital Loss to future tax years. The loss can be used to offset future Capital Gains and any remaining loss can be used to reduce taxable income (up to $3,000 a year).
Tax Loss Harvesting is great! The investment goes down in price, you immediately sell it and buy it back for the same price. You own the exact number of shares as before but now you can deduct the loss from your future taxes! Rinse and repeat.
Not so fast. The tax code people are smarter than that. They added the Wash Sale rule to stop you doing that. The US tax code imposes the following restriction:
A Wash Sale is triggered when you sell or trade stock or securities at a loss and within, 30 days before or after the sale, you buy substantially identical stock or securities in any account (taxable or retirement).
The effect of a Wash Sale is that it adds your loss back to the cost basis of the new purchase. There are some finer points to this topic so I’d recommend looking over Wash Sales for more information.
In this article, I’m assuming that no Wash Sales will be triggered by a sale due to careful planning and due diligence.
Substantially Identical Investments
The Wash Sale rules apply to buying back “Substantially Identical Investments”. There’s a fair amount of discussion on what exactly this means, but generally speaking:
- Individual stocks are never identical. Coca Cola (KO) would never be identical to Pepsi (PEP).
- Mutual Funds and ETFs are considered identical if they track the same index. So, the Vanguard S&P 500 Index (VFINX) would be treated as identical to the Fidelity 500 Index fund (FUSEX)
- Mutual Funds / ETFs that track different indexes are not considered identical.
- Actively managed funds are not considered identical.
Now selling shares of Coca Cola for a large loss and buying Pepsi would not be something I’d recommend. There’s little correlation between the two stocks even if they’re both competitors in the same market.
But what if you could sell something for a loss, and buy something that’s almost the same from the returns it provides, yet isn’t identical?
Practice meets Theory
So how do they do this?
They take advantage of mutual funds and ETFs which aren’t considered identical but yet will have similar performance over a short period of time.
Let’s say for example, that you own shares in the Vanguard S&P 500 Index (VFIAX). You’ve bought 100 shares at the start of each January from 2005 through 2009. At the beginning of 2010 the current market price is $104.32. (All prices in these calculations are the actual stock price at the time).
Note: In this example, dividends aren’t reinvested back into the investment and aren’t considered in the portfolio value. Additional purchases or reinvested dividends don’t affect the strategy but ignoring them keeps the example simpler.
So you currently have a market value of $52,160 but have a net loss of $5,540 on your investment. Let’s run two different scenarios and see the results at the end of 2010.
Scenario 1 – Stay the course
First you continue buying another 100 shares of VFIAX for $104.32 in 2010.
That’s not too bad. The price rose to $117.14 at the start of 2011 and the portfolio is back in the black as the stock market recovers.
Scenario 2 – Take the Tax Loss
Without substantially changing your stock allocation, you could sell the first four purchases (400 shares) at the beginning for 2010. This gives a capital loss of $7,397. To avoid a Wash Sale, you can’t purchase any additional shares of VFIAX for 30 days.
Instead you exchange the proceeds into (say) Vanguard Total Stock Market (VTSAX) for 30 days and sell back into VFIAX at the end of that period. To make it equal with the first scenario, I’m also going to add an additional $10,432 for the purchase of shares of VTSAX in 2010 since we’re not allowed to buy 100 shares of VFIAX.
Sell 400 shares at $104.32 => $41,728
Total Available Cash = $41,728 + $10,432 => 52,160
Price of VTSAX on 1/1/10 => $27.92
# of VTSAX shares purchased => $52,160 / $27.92 => 1,868.194
Price of VTSAX on 2/1/10 => $26.88
Sell 1,868.194 shares of VTASX => $50,217.05
Ouch – this sale results in another $1,942.95 short-term loss! Who came up with this stupid idea?
Scenario 2 – staying the course
We’re going to follow the plan and buy back VFIAX.
Price of VFIAX on 2/1/10 => $100.39
# of VFIAX shares purchased = $50,217.05 / $100.39 => 500.220
Huh? I lost $1,9425.95 in selling 400 shares, yet I was still able to buy back the number of shares I would have had, if I had not sold them.
Since VTSAX and VFIAX behaved similarly over this time period, it really doesn’t matter that the share price of VTSAX dropped. That’s because VFIAX dropped by a similar amount. In the month of January 2010, VFIAX declined 3.767% and VTSAX declined 3.725%.
The additional loss didn’t make a difference and in fact it’s even better since we end up with more Capital Losses at the end of 2011.
The investment remained at a similar final result as Scenario 1 ($70,309 instead of $70,284). Yet we gained a total capital gains loss of $9,339.95 ($7,397 +$1,942.95), some of which are short-term, that can be applied to future tax filings.
There is a cost with this approach however. What’s really happened is that we’ve taken a tax-free loan now but we’ve deferred the taxes. You can see that the Cost Basis is now lower than before since we locked in the loss, so now we have higher unrealized capital gains.
Scenario 3 – market timing
Having recently read Benjamin Graham’s, The Intelligent Investor, I feel inclined to add a Speculation Alert! for this section.
Just for completeness, we could have held onto the cash after selling VFIAX, and then bought $52,160 of VFIAX again in February.
Price of VFIAX on 2/1/10 => $100.39
#of VFIAX shares purchased = $52,160 / $100.39 => 519.574
Going to cash for this time period was actually beneficial. However, only because the market happened to go down from $104.32 to $100.39. It would have been harmful had the market increased over that period instead.
Scenario 2, since it didn’t really change your investments, would not be affected by the market direction. You’d end up buying back pretty much the same number of shares that you sold. You’re only dependent on the relative difference in performance between the two asset classes. Over a short period this difference should be minimal.
Scenario 3 is a more speculative strategy however. It should be avoided because the purchased asset is different from the sold asset. Buying cash is really no different than selling KO shares to buy PEP shares for a short time. It may come out ahead or it may not.
Income Fund Applicability
Because I want to keep my investments at Vanguard, substitute funds are more limited. But obviously the strategy itself can be used across brokerage accounts or mutual fund families.
It looks like the following funds might be reasonable substitutes that I could consider using if prices drop significantly.
|High Dividend Yield Index||Equity Income Fund (VEIRX)|
|International High-Dividend Yield||All World Ex-US (VFWAX)|
|Intermediate-Term Bond Index||Intermediate Term Investment Grade (VFICX)|
|High-Yield Corporate Fund||No equivalent|
Whether you use this approach or not depends on your personal situation and objectives. But it’s something to keep in mind as a potential tool in your investing toolbox.
This tactic isn’t very applicable in the rising stock market that we’ve had over the last few years. But it can be useful as a way to gain from a large market correction without changing your asset allocation.
This approach requires three main criteria to be successful:
- Investments must be in Taxable accounts. It makes no sense in a tax-advantaged account.
- There must be a suitable Substitute Fund / ETF which has a high correlation to the investment being considered for sale.
- There should be no additional fees / commissions from buying / selling the investments.
It helps too if your brokerage allows exchanges from one asset class to another. Otherwise, it’s best if you can fund the new purchase at the same time as the sale to minimize the time between the sale and purchase.
It also simplifies things if you can sell out of the entire position rather than just sell a portion as I did in the example above. Selling the entire position eliminates any wash sale restriction from a purchase 30 days before the sale. However it may incur short-term taxes if the investment you’re selling was bought recently.
You don’t escape the taxes either, since they’re deferred to a future date. But if you’re never planning to “really sell”, that’s not a problem.
I’m not a tax expert or professional advisor, so please consult a professional or perform your own due diligence based on your personal situation before making any investment decision.
Quote of the Day
I think one of the major results of the psychology of decision making is that people’s attitudes and feelings about losses and gains are really not symmetric. So we really feel more pain when we lose $10,000 than we feel pleasure when we get $10,000.