As stocks dip in price, investors can sell those stocks and recognize a loss for tax purposes. This loss can be used to offset other gains or lower taxable income, and, thus, the loss serves as an important tax benefit. To prevent abuse, Congress implemented rules disallowing taxpayers from harvesting these losses via a wash sale – a transaction where the taxpayer sells the stock at a loss and then buys it back within thirty days. However, it is unclear whether the wash sale rules apply to selling and buying a similar (but not the same) ETF. A recent academic study explores whether and to what extent taxpayers are taking advantage of this loophole to recognize tax benefits without triggering a wash sale.
Taxation Of Investments And Wash Sales
Taxpayers investing in the stock market record their basis in the stocks as the cost of purchasing them plus any transaction costs. This basis is important because, upon selling the stocks, it determines whether the taxpayer has a taxable gain or loss.
If the sales price is greater than the taxpayer’s basis, then the taxpayer has a taxable gain. The default treatment for taxes on a gain is for the taxpayer to pay taxes at the ordinary income tax rate, which can range from 10% to 37% based on the taxpayer’s taxable income. However, if the taxpayer holds the stock for one year and one day (or longer), then the taxpayer will pay taxes at a preferred long-term capital gains rate, which varies from 0% to 20% based on the taxpayer’s taxable income.
If the sale price is less than the taxpayer’s basis, then the taxpayer has a loss. While losing money on investments is not ideal, for tax purposes, a loss unlocks tax benefits. First, the taxpayer will not owe any taxes on this transaction. Second, the taxpayer can use this loss to offset the capital gains of another transaction. Lastly, if the taxpayer does not have any other capital gains to offset, they can use up to $3,000 of a net capital loss to deduct against ordinary income (thereby lowering taxable income for the year).
As there are clear advantages to selling a stock at a loss, rules had to be implemented to prevent taxpayers from claiming a loss while keeping the same investment. Under Section 1091 of the Internal Revenue Code, taxpayers cannot sell a stock at a loss and then buy the same or a substantially identical stock within a 30-day time frame. Failing to adhere to the 30-day window will result in the taxpayer not being able to realize the tax benefits associated with originally selling it at a loss.
It can be easy to identify when a taxpayer sells a share of a company and then buys that exact same company within a 30-day window. Where things get tricky is when what is being sold and repurchased is similar. For instance, many taxpayers own ETFs and indexes that have a similar composition to other ETFs and indexes. The current tax laws are much less clear about whether trades between these securities are subject to wash sale rules.
ETFs And The Wash Sale Loophole
Recently published academic research in Management Science considers the potential that institutional investors use ETFs to circumvent the wash sale rules. In a study titled “Exchange-Traded Funds and the Wash Sale Loophole”, researchers examined data from over 234,000 monthly ETF observations and 208,000 quarterly 13F Filer observations and found evidence consistent with the notion that investors are avoiding the wash sale rule via ETFs. This article is co-authored by Michael Dambra of the University at Buffalo School of Management, along with Andrew Glover, Charles Lee, and Phillip Quinn from the Foster School of Business at the University of Washington. Their study’s research question simply asks whether institutional investors use ETFs to harvest tax losses and circumvent the wash sale rule.
In discussing the key motivation for examining their research question, Glover states, “We read some media coverage of leaked IRS returns, which had examples of wealthy individuals’ tax saving strategies. One approach to avoid the wash sale rule when harvesting tax losses was for individuals to sell a firm’s A-class shares and immediately replace them with the same firm’s B-class shares.” This strategy was outlined by ProPublica as a way for wealthy taxpayers to sidestep the current wash sale laws. “We wanted to know if the same type of strategy could be enacted at a much larger scale by institutional investors hoping to harvest losses without really shifting their underlying economic positions, and ETFs comprised of very similar underlying securities seemed to provide ample opportunities,” stated Glover.
The study finds that, in recent years, about 25% of assets under management at tax-sensitive institutions are in highly correlated ETFs, meaning that the conditions are right for institutions to be selling and buying back into similar ETFs. In discussing the findings, Quinn states, “We estimate that tax-sensitive institutions swapped highly correlated ETFs to realize about $84 billion in losses between 2001 and 2022, and the prevalence of both the swapping behavior and loss realization is growing over time.” Thus, the prevalence of these activities has economically meaningful impacts on U.S. tax collections.
In discussing some of the results, Glover acknowledged a surprising inference from the data. He expressed, “Tax-loss harvesting with ETFs appears to happen year-round rather than being concentrated in the 4th quarter. We think this is likely because ETFs don’t present the same loss harvesting frictions as equities. For example, a fund manager isn’t swapping “losing tech firm A” for “winning tech firm B”. Instead, they are swapping exposure to the tech sector via tech ETF A for almost the same exposure to the tech sector via tech ETF B. Trading costs are low, tracking error is non-existent, and no change in investment thesis is required, so harvesting losses can efficiently happen year-round.” While these findings in no way contradict the research questions’ main results, they do shed light on how investors might consider and internalize the turn-of-the-year effect that often sees investors harvesting losses at year’s end.
The findings from this manuscript can have a substantial impact on taxpayers and policymakers alike. As indicated by Glover, “the wash sale rule was written for a world of stocks and bonds, not ETFs. In fact, the last substantive update to the rule was more than four decades ago, before ETFs even existed as an asset class. While the spirit of the rule certainly seems to be violated by swapping baskets of securities that are nearly identical, the letter of the statute relies on ambiguous “substantially identical” language. New securities have made the old rules easy to ignore.” This study joins other academic research suggestive of ETF tax advantages both due to the wash sale rule as well as in-kind redemptions.
These findings carry even more weight as the IRS continues to be in a funding spiral. If the taxing authority becomes even more limited in its ability to monitor and audit taxpayers, then it can become difficult to push back on taxpayers who may be sidestepping rules, like those that fall under the wash sale limitation. On the contrary, if the IRS prioritizes focusing on transactions like these, taxpayers may expect to see bigger delays and less support from the taxing authority in future tax seasons.
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