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Wednesday, July 12, 2006

USING ETF'S TO GET AROUND THE WASH-SALE RULE

If a taxpayer investor incurs capital gains in a year, typical tax planning involves also selling securities that are presently at a loss, to generate losses to offset gains and reduce taxes. After the loss property is sold, taxpayers often want to reacquire the property because they still consider it a good investment. However, Congress believes it is inappropriate to get a tax loss if you sell a security and then immediately buy it back. Thus, under the wash-sale rule, if an investor, within 30 days before or after the day of the sale of a security at a loss, purchases a "substantially identical" security, the loss on the sale is disallowed.

ETF's (exchange traded funds) are securities in an entity that owns a basket of stocks, such as stocks that make up a particular stock index or stocks of companies in a particular market sector. In a lot of ways they are similar to similarly structured mutual funds, except that the ETF's are traded directly on the stock exchange. The expanded use of ETF's provides some mechanisms for getting around the wash sale rules for investors in sector or index mutual funds. A recent article by Seddik Meziani and James G.S. Yang in the May 2005 issue of Practical Tax Strategies discusses some of these mechanisms and strategies:

a. Incurring mutual fund losses while maintaining market exposure through an ETF. If a taxpayer sells a loss position in a mutual fund, and then reacquires the mutual fund within the wash-sale period, the wash-sale rules will disallow the loss. If the taxpayer wants to continue the market exposure that was provided in the mutual fund, it should be able to buy an ETF with similar market coverage. Since the ETF will likely not be a "substantially identical" security to the mutual fund shares, this substitution of the mutual fund shares for shares of an ETF should not be subject to the wash-sales rules.

b. Incurring a sector ETF loss while maintaining market exposure to that sector. If a taxpayer sells a loss position in a market sector ETF, the taxpayer can maintain similar market exposure by acquiring directly several of the stocks in the sector that were owned in the ETF and that made up the largest positions in the ETF. While the taxpayer will still be less diversified in the sector than through the ETF, this should still allow for materially similar market exposure (at least until the wash-sale period expires and the ETF can be reacquired.

c. Swap one ETF for another. If a taxpayer sells a loss ETF, it may be able to find an ETF that is issued by a different company that has fairly similar market coverage. This should get the taxpayer around the wash-sale rule, although there is some uncertainty as how how different the ETFs need to be.
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