Author Topic: Tax Loss Harvesting, Index Funds, & Wash Sales  (Read 5227 times)

Eric

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Tax Loss Harvesting, Index Funds, & Wash Sales
« on: May 06, 2015, 03:53:44 PM »
Michael Kitces has a new article out talking about the wash sale rule, and specifically how it relates to index investing.  His conclusion is essentially that you can't tax loss harvest with indexes, at least according to the spirit of the law.  And of course in true Kitces fashion, he explains everything very thoroughly.

Being an index investor myself, and the fact that we've been in a bull market for forever, I haven't really had a chance to do this.  However it's been in the back of my mind since the Mad Fientist wrote about it a couple of years ago.

Kitces argument is that since the performance correlation even when switching between funds is so great, that they are substantially the same.  (or at least could be viewed by the IRS as such)  If you're interested, you should probably read the whole thing, but it essentially comes down to this:

Quote from: Kitces
And while arguably swapping from index funds like SPY to IVV are almost certainly a wash sale abuse (or at least, a transaction that should trigger the wash sale rules), what about situations like swapping from the S&P 500 to the S&P 100 (e.g., from IVV to OEF). To some extent, these are “different” index funds… except the reality is that any losses driven by the top 100 stocks in IVV will by definition by held in the replace OEF fund, overall almost 2/3rds of the S&P 500 is made up of the stocks in the S&P 100 anyway, and the two exhibit a whopping 0.983 correlation on their daily price returns over the past decade!

In fact, even switching index providers doesn’t actually yield much of a difference. For instance, going from the S&P 500 to the Russell 1000 (or from IVV to IWB) may sound like different index funds with different companies built in a different way… except their top holdings really are ‘substantially’ identical, and the only difference in their top-25 holdings at all is that the Russell 1000 replaces Comcast with IBM in the #24 and #25 spots. Over the past decade, their daily price changes had a whopping .0.991 correlation!

In fact, because the performance of large-cap stocks is so dominating in cap-weighted index funds, IVV actually has a 0.989 correlation to the Vanguard Total Stock Market fund (VTI) as well.  Unless the fund is extremely constrained – e.g., by some non-traditional weighting approach, or perhaps narrowly confined to a particular industry or sector – a huge portion of “different” ETFs based on differently-constructed indexes or from different providers still end out with extremely similar performance tracking, especially over time periods as “short” as a 30-day wash sale period.

Quote from: Kitces
Ultimately, there will no doubt be a large number of “grey” and murky situations, but I suspect that until the IRS provides better guidance (or Congress rewrites/updates the wash sale rules altogether!), in the near term the easiest “red flag” warning is simply to look at the correlation between the original investment being loss-harvested, and the replacement security; at correlations above 0.95, and especially at 0.99+, it’s difficult to argue that the securities are not ”substantially identical” to each other in performance.

I'm sure a number of you know more about this than I do.  What do you think?

(He also has a link in the article to the Wealthfront whitepaper about this topic, which I'd be interested to read but don't have time right now.)
« Last Edit: May 06, 2015, 03:56:01 PM by Eric »

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Re: Tax Loss Harvesting, Index Funds, & Wash Sales
« Reply #1 on: May 06, 2015, 04:04:54 PM »
I'm hoping we have someone that knows tax law in here, because I'm really interested to hear some educated thoughts on this.

At a minimum, this will seriously affect the products that Betterment and others offer. Wow.

Eric

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Re: Tax Loss Harvesting, Index Funds, & Wash Sales
« Reply #2 on: May 06, 2015, 04:11:51 PM »
Part of the problem, as he states, is that the IRS hasn't really offered any guidance on this issue.  So at the moment, it's sort of up to each individual (or individual company) to interpret what is a "substantially identical" fund and what isn't.  It can be legitimately argued either way that the S&P 500 and Russell 1000 are or are not substantially identical.  Do the extra 500 stocks make it different, or does the cap weight average that causes both funds to perform almost identically make them (substantially) the same?

beltim

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Re: Tax Loss Harvesting, Index Funds, & Wash Sales
« Reply #3 on: May 06, 2015, 04:21:37 PM »
Considering actively managed funds often have very high correlations with the S&P 500 (eg Dodge and Cox stock at .98), I don't think the IRS could reasonably use a correlation coefficient to say that two indices that differ by 400 holdings are substantially identical.

Indexer

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Re: Tax Loss Harvesting, Index Funds, & Wash Sales
« Reply #4 on: May 06, 2015, 04:28:59 PM »
So a 500 index for another 500 index.... I think it is a wash sale rule by the definitions BUT the IRS hasn't enforced to my knowledge.

However what about selling the total stock, and then buying the 500+extended?  Technically very different funds, but when you add the later together they equal the former. 

Quote from: IRS Publication 550

Wash Sales

You cannot deduct losses from sales or trades of stock or securities in a wash sale unless the loss was incurred in the ordinary course of your business as a dealer in stock or securities.

A wash sale occurs 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,

Acquire substantially identical stock or securities in a fully taxable trade,

Acquire a contract or option to buy substantially identical stock or securities, or

Acquire substantially identical stock for your individual retirement account (IRA) or Roth IRA.

 
If you sell stock and your spouse or a corporation you control buys substantially identical stock, you also have a wash sale.

If your loss was disallowed because of the wash sale rules, add the disallowed loss to the cost of the new stock or securities (except in (4) above). The result is your basis in the new stock or securities. This adjustment postpones the loss deduction until the disposition of the new stock or securities. Your holding period for the new stock or securities includes the holding period of the stock or securities sold.

The key term in all of this is 'substantially identical securities.'  My interpretation is that trading two 500 index funds from different companies would count, but the IRS hasn't enforced this.  My interpretation would also be that trading the total stock for extended+500 is substantially.... they are IDENTICAL.... securities.  The ticker symbol is different, but the underlying securities are the same.  I feel the IRS 'could' enforce this, but they don't.  I feel that the more this gets abused the more the IRS is going to care and come after it.

Lets just say if you got audited and you got a particularly zealous agent I wouldn't want to be the person trying to justify how it wasn't a wash sale violation. 

Not to long ago people were taking advantage of the IRA indirect rollover rules to basically loan themselves large sums for very long(longer than the 60 day) periods.  The IRS got tired of, and made an example out of a guy... now you can't do it. 

If the IRS wanted to make an example again... I wouldn't want to be Betterment or Wealthfront's top client.

Eric

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Re: Tax Loss Harvesting, Index Funds, & Wash Sales
« Reply #5 on: May 06, 2015, 05:27:58 PM »
If the IRS wanted to make an example again... I wouldn't want to be Betterment or Wealthfront's top client.

I doubt it would matter for the individual as the company would use their resources to back them.  However, if it became a point of emphasis, the IRS could substantially alter their business model benefit claims.
« Last Edit: May 06, 2015, 05:30:59 PM by Eric »

Indexer

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Re: Tax Loss Harvesting, Index Funds, & Wash Sales
« Reply #6 on: May 06, 2015, 05:51:57 PM »
If the IRS wanted to make an example again... I wouldn't want to be Betterment or Wealthfront's top client.

I doubt it would matter for the individual as the company would use their resources to back them.  However, if it became a point of emphasis, the IRS could substantially alter their business model benefit claims.

I highly highly HIGHLY doubt this.  If an investment advisor causes you to have a serious tax problem... the investment advisor and the IRS are clear on this... it's your taxes.  You can fire the advisor.  If it is especially bad maybe you can even sue them, but this is unlikely.  This is why if you call Vanguard/Fidelity/Schwab/etc. they will either avoid talking about taxes or preface any statement with consult with your tax professional. 

I doubt a robo advisor, lets call it what it is... a set of very basic online investing tools, is going to back you in an IRS audit.  When the IRS asks for forms, they are going to hand them over.  When you ask for help... there isn't even an advisor to talk to... send an email.... and don't expect a reply other than "We recommend you consult your tax professional." 


Actually a quick search revealed....  I was going to bold the important parts... but that would be the entire thing.
Quote from: Betterment
Tax loss harvesting is not suitable for all investors. Nothing herein should be interpreted as tax advice, and Betterment does not represent in any manner that the tax consequences described herein will be obtained, or that any Betterment product will result in any particular tax consequence. Please consult your personal tax advisor as to whether TLH+ is a suitable strategy for you, given your particular circumstances. The tax consequences of tax loss harvesting are complex and uncertain and may be challenged by the IRS. You and your tax advisor are responsible for how transactions conducted in your account are reported to the IRS on your personal tax return. Betterment assumes no responsibility for the tax consequences to any client of any transaction.

Eric

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Re: Tax Loss Harvesting, Index Funds, & Wash Sales
« Reply #7 on: May 06, 2015, 06:06:28 PM »
I'm not super familiar with Betterment.  Is there an option to choose yes or no for Tax Loss Harvesting?  Based on their advertising I assumed that it was just "included".

Plus, they can disclaim responsibility all they want, but it would be a PR nightmare for them to abandon their client when it was them doing the harvesting.  It would essentially put them out of business.  I'm reasonably sure that they'd back you if it was their system that caused you to get in trouble.  Otherwise, they wouldn't exist anymore.

brooklynguy

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Re: Tax Loss Harvesting, Index Funds, & Wash Sales
« Reply #8 on: May 06, 2015, 06:49:10 PM »
His conclusion is essentially that you can't tax loss harvest with indexes, at least according to the spirit of the law. 

He doesn't go quite that far - his conclusion is really that it's unclear just how different two index-based securities need to be from one another in order to avoid being considered "substantially identical" for purposes of the wash sale rules, which we've always known (Kitces certainly wouldn't argue that a stock index fund and a bond index bond are substantially identical, for example).

He makes a good argument that the substantial amount of overlap across many funds and ETFs poses the risk that the IRS or a court would characterize them as substantially identical, but I agree with beltim that high correlation alone isn't the proper standard.  There can be a high level of correlation between two securities that are clearly not substantially identical, and Kitces is really just using "level of correlation" as a proxy for "level of overlap in underlying securities."  But why use a proxy?  I would argue that it's the level of overlap that matters.  But until this issue is tested in court or the IRS provides guidance or Congress updates the law, this is really all just speculation.

***Like all of my posts on the forum, this does not constitute legal advice***

Indexer

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Re: Tax Loss Harvesting, Index Funds, & Wash Sales
« Reply #9 on: May 06, 2015, 07:11:34 PM »
I'm not super familiar with Betterment.  Is there an option to choose yes or no for Tax Loss Harvesting?  Based on their advertising I assumed that it was just "included".

Plus, they can disclaim responsibility all they want, but it would be a PR nightmare for them to abandon their client when it was them doing the harvesting.  It would essentially put them out of business.  I'm reasonably sure that they'd back you if it was their system that caused you to get in trouble.  Otherwise, they wouldn't exist anymore.

What would they do exactly even if they wanted to?  If the IRS decides that index funds tracking the same index or a combination of index funds matching another combination of index funds = substantially identical... what would Betterment do?  If the IRS made a major push to enforce existing rules in order to shut down TLH thats not the type of thing an attorney can save you or your client from.   Thats a fight you would need lobbyists for.  Betterment isn't big enough for that kind of fight, and it would affect all of their clients.  They couldn't afford to save all of them so I figure deny responsibility and suffer the PR pain is going to be better than setting a precedent it would save everyone. 

The IRS has made rulings and Congress has made tax related laws before that shut down entire ways of doing business if they considered them tax manipulation.  Certain types of life insurance, annuities, LPs, DPPs, stacking indirect rollovers, etc. have been labeled tax shelters or tax manipulation.  The companies who stayed in business by providing those services went belly up, and their clients normally ended up paying a lot more taxes.   So yea... Betterment probably wouldn't exist anymore.

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Re: Tax Loss Harvesting, Index Funds, & Wash Sales
« Reply #10 on: May 06, 2015, 07:53:27 PM »
I think VOO and SPY are problematic funds to swap. It's more or less the same 500 (502) stocks. The IRS may not come after you for it, but I wouldn't do it. Now, you could sell your VFIAX and for those 62 days buy VEXAX instead, and then swap back. The two would track each other pretty well. You'd take a small risk, but the correlation is pretty high. And there would be zero overlap between them.

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Re: Tax Loss Harvesting, Index Funds, & Wash Sales
« Reply #11 on: May 07, 2015, 12:45:48 AM »
This just cements the fact that I'm on the fence with Betterment et al. I'm going to stick with Vanguard until there's a little longer history on this tax issue and also with these advisers keeping their allocations. I'm still a little worried they're going to shift them in periods of underperformance.