- In a down market, you may consider tax-loss harvesting, which can turn portfolio losses into tax breaks.
- But you need to familiarize yourself with the "wash sale rule," which blocks you from buying a “substantially identical” asset within the 30-day window before or after the sale.
- With limited IRS guidance, this rule may be tricky for mutual funds and exchange-traded funds, experts say.
The end of June marked the worst first six months of a year since 1970 for the S&P 500 Index, which plummeted by more than 20% since January. But there's a silver lining: the chance to turn losses into tax breaks — as long as you follow the rules.
The strategy, known as tax-loss harvesting, allows you to sell declining assets from your brokerage account and use the losses to reduce other profits. Once losses exceed gains, you can use the excess to decrease your regular income by up to $3,000 per year.
"When clients are in loss positions, they're always interested in tax-loss harvesting," said certified financial planner Larry Harris, director of tax services at Parsec Financial in Asheville, North Carolina.
However, it gets tricky when you collect the tax break but still want portfolio exposure from that asset, Harris explained.
That's because of the so-called wash sale rule, which blocks you from claiming the tax write-off if you repurchase a "substantially identical" asset within a 30-day window before or after the sale.
To put it simply: If you violate the wash sale rule, you can't write off the loss and score a tax break.
How to define 'substantially identical'
While individual stocks may be easy, there's less IRS guidance on how "substantially identical" applies to mutual funds and exchange-traded funds.
"It isn't black and white," said Harris, explaining how the safest way to avoid trouble is to wait at least 30 days before repurchasing the asset in question.
However, it depends on the "facts and circumstances" of your case, according to the IRS. To stay compliant, the agency wants to see that your "economic position" has changed, Harris said.
Always document your position
With limited IRS guidance, it's critical to examine mutual funds and ETFs before repurchasing within the 61-day wash sale window, experts say.
"We review it on a case-by-case basis," said Mark Rylance, a CFP and president of advisory firm RS Crum in Newport Beach, California.
For example, it may be acceptable to go from a passively managed index fund to an actively managed fund. But you can't sell an S&P 500 index fund at a loss and rebuy the same S&P 500 index at another company, he said.
"I think at the end of the day, it comes down to the common sense test," Rylance added.
And it's best to keep records of your decision, Harris said, suggesting that investors keep records of why assets purchased within the 61-day window aren't substantially identical.