Can You Avoid the Wash-Sale Rule with ETFs and This Loophole?

Most wealthy people constantly look for legal ways to minimize their taxes, and the rest of us can learn from their tricks.

Some expand that to include tax reduction strategies that aren’t clearly legal but are at least defensible and haven’t been disallowed by the IRS.

“Harvesting” investment losses to offset realized gains, and (some) regular income can be completely legal if you don’t run afoul of the so-called “wash-sale rule.”

That’s where things start getting murky…

What is the “Wash-Sale Rule”?

The wash-sale rule is intended to prevent taxpayers from claiming a tax loss while keeping the investment that generated that loss. 

The rule says you can’t claim the loss if, within 30 days before or after selling at a loss, you buy a “substantially identical” investment, even if the purchase is in an IRA or other retirement plan.

This applies to buying the same security, acquiring it through a taxable exchange, or even buying a contract or option to buy that security.

Using ETFs to Circumvent the Wash-Sale Rule — a Legit Loophole?

You can use Exchange-Traded Funds (ETFs) to avoid the wash-sale rule in several ways. 

Here are three, from the clearly legal to the more questionable.

1. Sell a stock and buy an ETF following the relevant investment sector.

Say you bought 100 shares of company ABC in the healthcare sector a year ago for $10,000, and those shares have since dropped to $4000.

You sell the shares, realizing a $6000 long-term capital gains loss. 

You can use this loss to offset up to $6000 in realized long-term capital gains (if you held the shares less than 12 months this would be short-term capital gains loss), and if you don’t have enough such gains from other investments to offset, you can use the loss to offset up to $3000 in regular income ($1500 if married filing separately), carrying any remaining losses to future tax year(s) when you can use them.

The problem arises if you still believe in the company and the healthcare sector and don’t want to risk missing a potential jump in price during the 30 days when the wash-sale rule would disallow the tax loss.

The solution is to buy an ETF that follows the healthcare sector. 

This isn’t an identical security to ABC, avoiding the wash-sale problem.

2. Sell a mutual fund and buy a similar ETF.

One could argue that an index mutual fund and an ETF following the same index are not substantially identical because they charge different fees and may not own an identical mix of underlying stocks. The latter is because index funds like the S&P 500 approximate the weightings of stocks in the index.

This may allow you to sell shares of, say, Vanguard 500 Index Fund Admiral Shares (VFIAX) if the index drops, harvesting the tax loss, and replace them immediately with shares of Vanguard 500 Index Fund (VOO).

If you’re concerned the IRS may deem the two substantially identical because both are from Vanguard, you could instead buy shares of, e.g., SPDR S&P 500 ETF Trust (SPY).

3. Sell an Index ETF and buy an ETF from a different sponsor that follows the same index.

Here, the idea would be that if you sell shares of an ETF that declined in price, say, SPY, you could immediately buy shares in another S&P 500 ETF, e.g., VOO, at the same price point where you sold. 

Both ETFs follow the S&P 500, but the trustee of the first is State Street Bank, while Vanguard offers the latter. As a result, the two likely don’t share an identical weighting of the S&P 500 stocks and thus may not be considered substantially identical.

The IRS has yet to rule on whether they consider ETFs from different sponsors that follow the same index as substantially identical and do not (yet) enforce the wash-sale rule on ETFs. 

In general, the more people who save more taxes by using a specific loophole, the bigger a target this becomes for the IRS (though Congress may not accept that way of increasing revenue).

Should the IRS so rule (and should Congress not overrule them), the result could be one or more of the following:

• Future use of the loophole will be illegal.
• Past use of the loophole would be disallowed, with back taxes owed.
• Should the IRS rule this is tax fraud, those who used the techniques in question may also be subjected to monetary and/or other penalties.

Even the Pros Don’t All Agree on What’s Acceptable

Melody Brady, Founder of Beechmont Financial, would be comfortable with these methods, saying, “I often rebalance my portfolios to realize a capital loss for tax harvesting by swapping an ETF for a similar one managed by a different manager, or a similar mutual fund. There’s always talk of tax legislation changing, but I only pay attention when it’s close to being passed before I adjust how I rebalance my portfolios.”

Douglas M. Lynch, President, Lynch Financial Group, LLC, argues, “Indeed, the IRS hasn’t clearly defined what substantially identical means, so the issue is somewhat muddy. However, we wouldn’t recommend an investor sell one S&P 500 Index fund and buy another S&P 500 ETF or a fund from an alternate provider. I’d have a hard time arguing to the IRS the funds aren’t substantially identical. We’d recommend buying an index fund that tracks a similar but different index. For example, we’ve sold an S&P 500 fund to harvest tax losses and purchased the Schwab 1000 ETF (SCHK).”

Alison Roth, Financial Advisor at AdvicePeriod, agrees, saying, “There’s never a perfect way to harvest losses and maintain an identical exposure (both upside and downside) without triggering the IRS wash sale rule. That said, we use two approaches: 1) With an individual stock, we’ll sell a company to harvest losses, and purchase a comparable one in the same industry, e.g., Pepsi versus Coca-Cola, to avoid wash sale rules. While each has company-specific risks and unique drivers of performance, owning Coca-Cola for the necessary time will at least provide exposure to the overall sector/industry. 2) With ETFs or mutual funds, we’ll harvest one fund for losses, then purchase a replacement that performs similarly, but tracks a different index. For example, if you sell an ETF that tracks the S&P 500, instead of purchasing a replacement ETF that also tracks the S&P 500, you might purchase one that tracks the Russell 1000 that has similar upside/downside, risk, and exposure. While tax loss harvesting can add value for many different investors, the IRS wash sale rule certainly leaves elements up for interpretation, so it’s important to avoid potential issues down the line.”

Anthony Ferraiolo, Partner Advisor of AdvicePeriod, feels similarly, “Tax loss harvesting can be a powerful tool, but there’s some gray area. Of the three strategies, the only one I’d suggest to clients is #1. The rule says you cannot buy substantially identical assets, so I wouldn’t feel comfortable switching to an ETF following the same index. Instead, I’d suggest investors swap, e.g., from an S&P 500 ETF to one following the NASDAQ Composite Index; similar indexes based on environmental, social, and governance (ESG) considerations; or, for an individual stock, finding a similar company in the same industry. You can look at the correlation between the two assets to feel more comfortable with the switch. By being more strategic, you avoid adverse tax consequences.”

Another Interesting (and Fully Legit) Tax Benefit of ETFs

Mutual funds are required to distribute annually to their investors any realized capital gains, whether or not you owned the shares when those gains were realized.

This can cause a distorted result if XYZ fund soars 50% from January to June when you buy shares, after which the share price drops 20% by the end of the year. 

In this scenario, you lose 20% on your investment but may be taxed on up to 30% of realized capital gains from which you did not benefit.

ETFs provide authorized participants who serve as a buffer, insulating investors from taxable events triggered by the ETF selling shares in its underlying investments. 

This way, you only get taxes on your actual gains, if any, realized when selling the ETF shares.

The Bottom Line

ETFs open up several interesting ways of circumventing the IRS’s “wash-sale” rule, letting you harvest tax losses while maintaining a similar investment position to avoid missing out on a potential rapid price appreciation.

These ways vary from the clearly legit to the questionable.

Should the IRS rule that one or more of these is not allowed, the impact on taxpayers will be preventing future use of the loophole, possibly owing back taxes, and potentially being assessed financial and/or other penalties.

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Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.