Whenever the market has had a tough year, investors have the option of making lemonade out of whatever lemons by turning losses into something useful.
The main strategy is called tax-loss harvesting, and it’s something that many financial advisors recommend and many robo-advisors offer as part of their investing plans. The strategy involves selling an investment at a loss, and then reinvesting that money in a similar security. With this approach, you can use the loss to offset capital gains taxes while still maintaining exposure to whatever it is you want to invest in.
But the key question here, is how similar can these two securities be? According to long-standing IRS rules, you cannot use a loss for tax purposes if you sell and rebuy the same security – stock or index fund or ETF – within 30-days. That’s called a “wash sale.”
The partially-open IRS did not respond to a request for comment, and as a Vanguard white paper on tax-loss harvesting says: “The IRS has not provided a definition of what constitutes a ‘substantially identical’ security.”
In lieu of meaningful guidance, many advisory firms seem to have found a clever loophole: buy someone else’s version of an index fund or ETF, or go ETF to mutual fund.
According to a note from Datatrek Research, “This has become a common practice in the last decade, even with (or perhaps because of) murky Internal Revenue Service guidance around wash sales.”
So how do firms actually interpret “substantially identical?” It’s not the same everywhere.
Vanguard said it takes a more conservative approach, and considers tax-loss harvesting from one fund to another a wash sale if they have similar characteristics.
“We consider tax loss harvesting from one fund to another that has identical characteristics to be a wash sale,” Julie Virta, a financial advisor at Vanguard Personal Advisors Services, told Yahoo Finance. “For example, we might exchange one broad international index fund for another broad international index fund, but with a different benchmark and underlying sub-asset allocation.”
Another option that Vanguard also uses: “exchanging an index fund for an actively-managed fund within the same class.”
According to Datatrek’s note, this was a popular strategy amid 2018’s market turbulence, but largely happening the other way – selling a mutual fund at a loss and reinvesting in a comparable ETF. Jumping from ETF to mutual fund or vice versa seems to be enough to avoid the wash sale rule, at least until the IRS clarifies — something that is unlikely especially given an already-understaffed and now partially-open IRS.
A popular selling-point for robos over DIY
Robo-advisor Wealthfront said it would buy another company’s version of a similar ETF. A spokesperson gave an example: Swapping Vanguard’s Total Stock Market ETF (VTI) for Schwab’s U.S. Broad Market ETF (SCHB). It also uses iShares Core S&P Total Stock Market ETF (ITOT) as another option.
All three of these are considered to represent “the U.S. stock market,” including both small- and large-cap stocks. But though all three are compared to each other and are essentially interchangeable, they are slightly different and track different indexes. VTI has around 4,000 components and tracks the CRSP US Total Market Index, SCHB has 2,500 and its benchmark is the Dow Jones U.S. Broad Stock Market Index, and ITOT has 1,500 and tracks the S&P Total Market Index.
“You need to use two securities that track different indexes to avoid violating the ‘substantially identical’ clause of the wash-sale rule,” said Wealthfront’s Kate Wauck. “Swapping an ETF with another that tracks the same index from a different issuer (i.e., Vanguard vs. Schwab) would violate that ‘substantially identical rule.’”
In its white paper on the matter, Betterment echoes Wealthfront, writing that “while the IRS has not issued any guidance to suggest that [two index funds that track the same index] are ‘substantially identical,’ a more conservative approach when dealing with an index fund portfolio would be to repurchase a fund whose performance correlates closely with that of the harvested fund, but tracks a different index.”
Robo-advisor Wealthsimple said it behaves similarly when it comes to tax-loss harvesting, and buys a “similar ETF” as the one sold, but also using a different exchange like the Nasdaq vs. the NYSE.
Neither of these three robo-advisors offer an S&P 500-indexed ETF, and Wealthfront confirmed that it doesn’t use one precisely because it would strip investors of the ability to tax-loss harvest, because an S&P 500-indexed ETFs would use, obviously, the same index. Even if broad indexes track each other like a shadow, there’s still enough to plausibly say they’re different.
Or maybe you can swap S&P 500 index ETFs? No one really knows.
Most money managers and advisors tend to be conservative with this strategy.
“I would take the position from a tax perspective that if you buy one S&P 500 index fund and replace it with an identical S&P 500 fund through a different vendor, in essence, you have bought and sold the same security,” said John Vento, president of Comprehensive Wealth Management. “I would not recommend using this strategy as part of your tax-loss harvesting. It would be best to buy a mutual fund that is not identical to the S&P 500 index fund you just sold.”
But some do think the IRS’s guidance is vague enough to allow something like a straight up swap of one company’s S&P 500 ETF for another.
“If you sell one company’s S&P 500 Fund and buy another company’s, are they substantially identical? I would argue no,” says Craig Richards, director of tax services at Fiduciary Trust Company International. “I do not believe you need to move to a mutual fund in order to accomplish [tax loss harvesting].”
Richards pointed to the fact that not only are they products of different institutions, different ETFs of the same index could still have “different structure (open-end fund, UIT, grantor trust, ETN, partnership), expense ratios, returns, price per share, size/AUM, management, creation date/longevity of ETF, and security lending agreements.”
“I would argue that there are typically sufficient differences between ETFs from one company to another that without further guidance from the IRS on the matter, they may not be substantially identical,” he said.