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Advisor Insights

Wash Sale Challenge: What Is Substantially Identical?

The key to proper tax-loss harvesting comes down to "facts and circumstances."

In times of market volatility like we have had over the past year, the most effective advisors are busy harvesting tax losses to help offset their clients’ realized gains.

The easy part is to identify positions that have accumulated significant losses and then sell them to recognize the losses for tax purposes. But then, how to maintain the clients’ investment allocations after the sale? That’s where the complications begin.

The challenge is navigating the “wash sale” rules promulgated by the Internal Revenue Service that nix buying back the same or “substantially identical” securities within 30 days of the sale.

The question is: What the heck does "substantially identical" mean, especially when it comes to mutual funds--both open-end and exchange-traded funds. In this column, I’ll walk through some of the nuances of IRS decisions over the year, mainly as it related to funds, and the importance of “facts and circumstances.”

The Background
As of 1921, Internal Revenue Code section 1091 was enacted, which states “In the case of any loss claimed to have been sustained from any sale or disposition of shares of stock or securities where it appears that, within a period beginning 30 days before the date of such sale or disposition and ending 30 days after such date, the taxpayer has acquired ... substantially identical stock or securities, then no deduction shall be allowed.”

The law’s purpose was to prevent taxpayers from recognizing losses without any actual change in economic position.

To ensure their clients’ tax losses, advisors have two choices with the proceeds: Stay in cash for 30 days following the sale or buy something else that is similar, but not substantially identical.

Staying in cash for 30 days, of course, has an opportunity cost. It could cost the client more than the tax benefits should the former position experience a rise in price within the 30 days. That’s too risky.

As a result, most advisors will buy a substitute position right away to keep the clients invested as per their individual investment policies. Thus, if they sell $50,000 of Apple stock to recognize a loss, they might buy $50,000 of Microsoft shares to keep their client fully invested during the 30 days. Whether or not to sell the Microsoft and repurchase Apple after the 30 days is at the advisor’s discretion.

What Is Substantially Identical?
But, how can an advisor know for sure that the replacement position is not substantially identical? Unfortunately, the U.S. Congress wrote the law with a huge ambiguity, leaving out a specific definition of what would constitute identical. For this reason, over the past 100 years, taxpayers have had to rely heavily on Revenue Rulings, case law, and their own best judgment to interpret this vague rule.

Thus, in defining substantially identical, taxpayers must look to every form of guidance available and, ultimately, form their own opinions. Perhaps the most relevant tool could be the “facts and circumstances” test, a standard seen throughout the Internal Revenue Code and case law. This standard directs the taxpayer to look at the entire context of a situation before reaching a conclusion.

In the case of substantially identical, the most relevant guidance appears in Publication 550, which states, “In determining whether stock or securities are substantially identical, you must consider all the facts and circumstances in your particular case.” The Publication clarifies that “ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation.” It also adds that “bonds or preferred stock of a corporation are not ordinarily considered substantially identical to the common stock of the same corporation.”

Application to Mutual Funds and ETFs
Since the introduction of the wash sale rule, stocks and bonds have always been the primary focus of the IRS and Tax Court. Nearly every IRS publication, and all Revenue Rulings, dealt with stocks or bonds, not mutual funds or exchange-traded funds. The regulation of wash sales began with the Revenue Act of 1921, whereas the first open-end mutual fund was created in 1924.

Furthermore, it wasn’t until the Securities Act of 1933 that the mutual fund industry became heavily regulated. ETFs would come much later. There was also no explicit interpretation of wash sales in relation to mutual funds until Publication 564 (discontinued in 2009), which stated:

“In determining whether the shares are substantially identical, you must consider all the facts and circumstances. Ordinarily, shares issued by one mutual fund are not considered to be substantially identical to shares issued by another mutual fund.”

The IRS included “ordinarily” in the description without any indication as to what that meant. This could be interpreted to mean that a substantial difference in management or a substantial amount of overlap in similar mutual funds could constitute a substantially identical position.

Michael Kitces writes that differences in the proportions of the underlying securities, how the fund is managed, and the identity of the manager have been enough to allow the mutual fund market, for the most part, to operate without fear of triggering wash sales.

The nonspecific language in Publication 564 does not provide clarity with respect to mutual funds. Without clear guidelines, taking advantage of tax-loss harvesting with mutual funds could subject the taxpayer to back taxes, interest, and potential penalties should an IRS audit classify a transaction as a wash sale. Thus, to use tax-loss harvesting strategies with mutual funds, it is essential that investors and their advisors establish a personal set of parameters to provide a measure of assurance against wash sales.

Applying the “facts and circumstances” concept to the determination of substantially identical mutual funds could justify drawing a line at any point along the continuum. On one end of the scale, minor differences in funds could be seen as not substantially identical. This could justify different share classes of the same fund or equivalent index funds offered through different fund companies. On the other end of the scale, only major differences in funds would support a finding of not substantially identical. With this interpretation, funds would need to hold entirely different positions to avoid being substantially identical. As the IRS and courts have held, facts and circumstances consider the weight of the evidence. Thus, the line marking substantially identical lies somewhere between the extremes of exactly alike and completely different.

A Suggested Rule of Thumb for Mutual Funds and ETFs
Although a clear difference in management approaches could be enough to justify treatment as not substantially identical, a potentially “safe” definition of not substantially identical mutual funds can be gleaned from the straddle rules. The Code of Federal Regulations contains a more definitive set of guidelines when establishing similarity in relation to an option straddle. A straddle under IRC section 1092 is “the holding of two or more positions in personal property in which the holding of one substantially diminishes the risk of loss in holding the other” (Gordon, 1996). With regard to straddles, the code states “a position reflecting the value of a portfolio of stocks is substantially similar or related to the stocks held by the taxpayer only if the position and the taxpayer’s holdings substantially overlap as of the most recent testing date” (Treasury Regulation 1.246-5). In order to avoid being substantially related, the fund sold at a loss must have equal to or less than 70% overlap with the tax-loss harvesting alternative. Although the 70% line applies to straddles, it could be useful when comparing mutual funds.

In attempting to apply this guideline to mutual funds, the first step is determining which securities are held by both funds and what proportion of the market value they represent. This can be a daunting task if you are trying to analyze all the positions and calculations by hand, so selecting the top 20 or so will suffice (Treasury Regulation 1.246-5).

Advisors must evaluate each fund and consider all material facts. Mutual funds have many distinguishing characteristics, with holdings proportions as just one. Moreover, not all of the distinguishing characteristics would be considered material. If two highly correlated funds were both actively managed by different managers, they might not be considered substantially identical. If one fund were actively managed and the other were passive, it is likely that they would not be considered substantially identical. However, if both were index funds (having no substantial involvement by a manager or any distinguishing strategy), the gross violation of the 70% threshold would pose a higher risk of wash sale.

For example, let’s look at top holdings of three mutual funds: Vanguard Index 500, T. Rowe Price Index 500, and DFA Large Cap Equity.



In this example, the three funds differ by at most two securities. It would be hard to argue that the holdings were not substantially identical. However, the Vanguard and the T. Rowe Price funds are both index funds based on the S&P 500 index. The DFA fund is not a “pure” index fund, and its benchmark is the Russell 1000 Index. It would appear safe to assume that the DFA fund is not substantially identical to the other two funds.

Although no ruling has been made on wash sales triggered by substantially identical mutual funds, a cautious investor and advisor must consider all the facts and circumstances of each transaction in question to determine material aspects. Like stocks and bonds, it is possible for several material features, when considered together, to constitute a substantial similarity or difference. Overlap evaluation is just one part of the determination.

In the end, the “facts and circumstances” concept is of primary importance, requiring the evaluation and weighting of all relevant, material features in determining "substantially identical."

References:
Hanlin v. Commissioner of Internal Revenue, 108 F.2d 429, U.S. Court of Appeals, Third Circuit. Nov. 27, 1939.

Kitces, M. 2015. "Does Tax Loss Harvesting 'Almost' Substantially Identical Mutual Funds and ETFs Trigger a Wash Sale Problem?" May 6, 2015. Kitces.com.

Michaels, G., Fang, W., & Tilkin, D. 2013. “Publication 550: Investment Income and Expenses (Including Capital Gains and Losses). 2014. Department of the Treasury. Internal Revenue Service.

Publication 564: Mutual Fund Distributions. 2014. Department of the Treasury. Internal Revenue Service.

Revenue Ruling 58-210, 1958-1 C.B. 523, Sec. 1091, IRS.

Revenue Ruling 58-211, 1958-1 C.B. 529, Sec. 1091. IRS.

Revenue Ruling 77-201, 1977-1 C.B. 250, Sec 1091, IRS.

Treasury Regulation 1.246-5. Reduction of Holding Periods in Certain Situations.

Sheryl Rowling, CPA, is head of rebalancing solutions for Morningstar and founder of Rowling & Associates, an investment advisory firm. She is a part-time columnist and consultant on advisor-focused products for Morningstar, and she continues to actively work in the advisory business. Morningstar acquired her Total Rebalance Expert software platform in 2015. The opinions expressed in her work are her own and do not necessarily reflect the views of Morningstar or of Rowling & Associates LLC.