Wash sale

According to the Merriam-Webster Legal Dictionary, the legal definition is "a sale and purchase of securities that produces no change of the beneficial owner."[2] The IRS broadened its definition of wash sales in 1993.[6] In the United States, wash sale laws are codified in "26 USC § 1091 - Loss from wash sales of stock or securities". The corresponding treasury regulations are given by CFR 1.1091-1[7] and 1.1091-2.[8]

Under Section 1091, a wash sale occurs when a taxpayer sells or trades stock or securities at a loss, and within 30 days before or after the sale:[9][10]

1. Buys substantially identical stock or securities,
2. Acquires substantially identical stock or securities in a fully taxable trade,
3. Acquires a contract or option to buy substantially identical stock or securities, or
4. Acquires substantially identical stock for an individual retirement account (IRA).

The "substantially identical stock" acquired in any of these ways is called the "replacement stock" for that original position. The IRS has not formally defined what "substantially identical" funds are constituted of.[5]

In the United States, the wash sale rule has the following consequences:

1. The taxpayer is not allowed to claim the loss on the sale (the loss is not "realized").
2. Basis Adjustment: The disallowed loss is added to the cost basis of the replacement stock.
3. Holding Period: The holding period for the replacement stock includes the holding period of the stock sold.[11]

In the United States, reporting wash sale loss adjustments is done on the 1099-B form.[12] According to Forbes, "most brokers don't report wash sale (WS) loss calculations during the year". For the IRS, taxpayers in the United States must calculate their WS losses "across all taxpayer's brokerage accounts, including IRAs and spousal accounts if married/filing joint.[13] Wash sale rules can also be avoided by "not buying a security within 30 days of selling the same one or a similar one for a loss."[14]

Tax loss harvesting (TLH) is a technique for "generating" capital losses. It occurs when an investor sells a security that has depreciated in value.[16][17] CBS News describes tax loss harvesting specifically as "selling an investment at a loss with the intention of ultimately repurchasing the same investment after the IRS's 30 day window on wash sales has expired." This allows investors to lower their tax amount with the use of investment losses.[5] Tax loss harvesting can be done throughout the fiscal year, allowing investors to "offset capital gains with capital losses."[18] If an investor has more capital losses than gains in a year, that year they can use up to $3,000 as a deduction to "offset ordinary income", with the remainder carrying over into future years if unused.[19] Loss harvesting defers taxes, but doesn't eliminate them, and is essentially receiving a loan without interest from the federal government, assuming marginal tax rates are the same.[20] If marginal rates are different, then there can be additional tax savings (e.g., deducting excess losses against a higher ordinary income rate in one year in exchange for additional long term capital gains tax at a lower rate in a later year) or even a tax penalty (e.g., deducting at a lower capital gains tax rate in several years in exchange for a much larger gain in one later year that puts one in a higher capital gains tax and Medicare investment income tax bracket.)[21]

Most simply, if "tax-loss harvesting is not done properly, it will create a wash-sale that will eliminate the tax benefits of the buying and selling".[22] The investor can employ a number of techniques to avoid triggering the wash sale rule.

1. The investor can wait 30 days to repurchase the security.[23]
2. The investor can purchase a security that is similar to the original, but that does not meet the IRS's definition of "substantially identical". For example, an investor can sell an ETF and buy another with similar investment objectives.[24]

Most tax loss harvesting historically has been performed in December.[25] Tax-loss harvesting is still most common in the year's fourth quarter. The practice has been both praised and criticized by investors, as deferring the taxes can result in higher rates later on relating to capital gains.[21]

Mean-variance portfolio optimization

With an initial set of portfolio weights ${\displaystyle w_{0}}$ and benchmark weights ${\displaystyle w_{B}}$, it is possible to do TLH within the confines of mean-variance optimization by developing an objective function[30] that maximizes the difference between tax alpha and the portfolio's tracking error:[31]

$${\displaystyle \max _{w}\;\underbrace {\alpha ^{T}(w-w_{0})} _{\text{Tax Alpha}}-\underbrace {{\lambda \over {2}}(w-w_{B})^{T}\Sigma (w-w_{B})} _{\text{Tracking Error}}}$$

where ${\displaystyle \lambda }$ is a penalty term for excess tracking error and ${\displaystyle \Sigma }$ is the covariance matrix of asset returns. For each asset that is bought/sold, it is necessary to include the constraints:

$${\displaystyle {\begin{cases}w_{j}\geq w_{0,j},\quad &({\text{Buy Trades}})\\w_{j}\leq w_{0,j},\quad &({\text{Sell Trades}})\end{cases}}}$$

With this formulation, the TLH optimization may be applied within a mean-variance framework. The solution is readily computed using quadratic programming.

• Ex-dividend date, where favorable tax treatment of qualified dividends is contingent on a 60-day holding period, similar to the wash sale rules.
• Round-tripping, a type of accounting fraud practiced through asset swapping, resembling wash sales within a group of participants.

• Wash Sale, Merriam Webster