Managing Your Investment Losses in a Tax Efficient Way
America is awash with investment losses this year. One way to alleviate the pain is to share the losses with the U.S. Treasury. The easiest method to accomplish this is by selling loss assets, and taking a tax loss. There are limitations on how much and what type of losses you can take, depending on whether you are an individual, or a corporation, and whether you are a dealer, a trader or an investor, amongst other things. But even once you have sorted out those questions, there is the (not insurmountable) hurdle of the wash sale rules.
The wash sale rules disallow an investor’s loss on the sale of stock or securities if, within a 30 day period immediately before or after the sale, the investor buys or enters into a contract or option to buy substantially identical stock or securities.
The three critical concepts in the wash sale rules are (1) sale of "stocks or securities," (2) purchase of "substantially identical stocks or securities," or certain derivatives of these and (3) the 61 day period on either side of the loss sale.
Because the wash sale rules are written narrowly, with careful planning an investor may be able to take his losses without being completely unexposed to the loss securities for 31 days. A summary of some techniques follows. They are brief descriptions only, and investors must discuss these and other ideas with their tax advisors before embarking on a plan of action.
(1) Doubling up
When an investor wishes to realize a loss on a particular block stock, but also remain exposed to the stock, the investor can buy the same amount of stock as is in the loss block, hold both blocks of stock for at least 31 days, and then sell the loss stock.
If an investor sells its stock at a loss and then enters into the long side of certain types of swaps, the investor may not fall afoul of the wash sale rules and may be able to take her loss on the stock. Some practitioners have questioned whether this technique still works in the light of the recent change in the rules to include cash-settled options and forwards/futures contracts. But it could be argued that even with the new cash-settled rule, swaps may still be an effective tool for managing investment losses.
(3) Purchase of a put option
An investor who closes a short sale at a loss and enters into an additional short sale of, or sells substantially identical stock or securities, within the 61 day period of the closing of the short sale at a loss, is also subject to the wash sale rules. The wash sale rules on short sales are different from those on long stocks, and so it could be argued that if an investor closes its short sale on a stock position at a loss and then enters into certain types of puts on the on the same stock, the wash sale rules do not apply.
These are some simple ideas to manage the wash-sale rules. There are more complex ideas too, that might be worked out with the help of an investor's tax and portfolio advisors. The most important message of this Alert is to think about managing investment losses in a tax-efficient manner.
IRS Circular 230 Disclosure: To comply with certain U.S. Treasury regulations, we inform you that, unless expressly stated otherwise, any U.S. federal tax advice contained in this communication, was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding any penalties that may be imposed on such taxpayer by the Internal Revenue Service. In addition, if any such tax advice is used or referred to by other parties in promoting, marketing or recommending any partnership or other entity, investment plan or arrangement, then (i) the advice should be construed as written in connection with the promotion or marketing by others of the transaction(s) or matter(s) addressed in this communication and (ii) the taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor. To the extent that a state taxing authority has adopted rules similar to the relevant provisions of Circular 230, use of any state tax advice contained herein is similarly limited.
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