New twists on an old plot: investors look to avoid the wash sale rule by harvesting tax losses with exchange-traded funds.

Author:Fischer, Garrett M.
 
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On October 7, 2007, all seemed well on Wall Street as the Dow Jones Industrial Average (DJIA) set a "record high," closing at 14,164. (1) But, as expressed by Sir Isaac Newton, "what goes up must come down." (2) And the U.S. stock markets came plummeting down at record pace, (3) declining by over fifty percent (4) "for the second time this decade." (5) As a result, the decline of the DJIA alone led to $11.2 trillion of investment losses between October 2007 and March 2009, (6) contributing to over $2 trillion of losses in U.S. "retirement savings." (7) As multiple financial institutions failed (8) and "credit markets froze," (9) investors "fear[ed] another Great Depression." (10)

Investors have traditionally been able to capitalize on long-term increases in the value of stocks (11) by utilizing the simple strategy of "buying low and selling high." (12) However, now that the United States is "facing one of the largest financial crises in history," (13) investors may look to maximize their returns through more creative investment strategies. Accordingly, this Note will analyze the proper taxation with respect to the Wash Sale Rule (26 U.S.C. [section] 1091) (14) for investors who creatively use contemporary investment mechanisms, known as exchange-traded funds (ETFs), (15) to minimize the effects of capital losses (16) through a process known as tax loss harvesting. (17)

Part I of this Note will provide an introductory explanation of tax loss harvesting, followed by an introductory explanation of the Wash Sale Rule in Part II. Then, in Parts III and IV, respectively, this Note will provide an explanation of ETFs and their history. In Part V, this Note will provide an in-depth discussion of the statutory language and administrability of the Wash Sale Rule. Finally, Part VI of this Note will provide an explanation as to why a proper analysis of ETFs under the Wash Sale Rule should entail a look at the underlying holdings of each ETF to determine if the funds are economically similar.

  1. INTRODUCTION TO TAX LOSS HARVESTING

    One method of "making lemonade out of ... stock market lemons" (18) is to take full advantage of tax strategies provided in the U.S. Tax Code (the Code). (19) It seems ironic that taxpayers would look to the tax system to provide relief from their capital losses when so many feel that the tax system is a mere hindrance to their economic positions; (20) however, Congress's general policy to only tax gain or enrichment (21) compels the Internal Revenue Service (IRS) to provide favorable tax treatment for losses on capital assets. (22) In turn, a taxpayer, other than a corporation, may subtract his capital losses from the capital gains he realized (23) during the taxable year, (24) consequently reducing the amount of taxes owed. If the capital losses exceed the capital gains, the taxpayer may further deduct the excess losses or $3,000, whichever is less. (25) And if, after taking the allowed deduction, the taxpayer still has remaining capital losses, he may carry those losses forward to future years. (26) With capital losses reaching far into the trillions of dollars for 2008, (27) these deductions can be tremendously valuable in offsetting current or future capital gains. (28)

    The significance of these deductions is further enhanced by the fundamental structure of the U.S. tax system, which provides that "investment gains and losses are not recognized until the investment is sold." (29) Thus, by controlling when they sell the investment, taxpayers have the ability to determine at what time they are taxed. (30) When the allowed deduction for capital losses is combined with the ability to control when one is taxed, an incentive is created to ignore the traditional adage of "buy low and sell high" (31) and, instead, sell low and look to use capital losses to offset current or future capital gains.

    This incentive is what lies behind the process commonly known as tax loss harvesting. (32) Tax loss harvesting is "the process of selling securities at a loss from their original cost, ... creating a capital loss, which is then used to offset other capital gains produced throughout the year, as well as future gains." (33) Thus, consider an investor who purchased 1000 shares of Corporation X for $30,000, the value of which has declined to $20,000. The investor could consider selling his position in Corporation X in order to harvest his losses. Essentially, the $10,000 tax loss realized could be used to "offset other capital gains that may have been produced through the year." (34) So, if the investor has $2000 of total capital gains for the year from other investments, his $10,000 capital loss would reduce his tax liability for the capital gains to zero, and the remaining $8000 loss could be used to offset future capital gains. (35)

    When investors sell their securities for losses, they not only have the opportunity to offset capital gains, but they also liberate cash--previously tied up in the investment--that can subsequently be reinvested. (36) Investors will particularly want to reinvest their capital if they believe that the market has reached its financial "bottom" (37) because they will expect a "steady increase" (38) in the price in the near future. Expectations of upward trends following significant decreases in the market are not without justification, with the Standard & Poor's (S&P) 500 Index (39) increasing by an average of 21.36% within six months, following the past seven bear-market bottoms. (40) More specifically, the DJIA has increased by 49.29% since its lowest position on March 9, 2009, (41) while the S&P 500 has increased by 52.35%. (42)

    Therefore, considering the fact that investors have the ability to choose when their tax gains or losses are to be realized through a sale or disposition of the security (43)--as well as the fact that financial markets often increase substantially following a financial bottom (44)--it is logical to conclude that an investor will try to maximize his investment returns by attempting to sell his securities at the lowest point in order to offset the largest amount of capital gains, before immediately repurchasing that same security so that he may benefit from the upward trend that will likely follow. Following this procedure, the investor could enjoy the deduction of capital losses against his future capital gains, without ever losing his economic position in the security. (45)

  2. INTRODUCTION TO THE WASH SALE RULE

    Although the tax laws can be generous toward investment returns in some instances, (46) Congress sought to prevent an investor from harvesting his tax losses while also maintaining the same economic position. (47) This is to say that Congress does not want an investor to be able to sell a security for a capital loss, deduct that loss against his capital gains, and then immediately repurchase the same security in order to benefit from future increases in price. (48) Accordingly, Congress, in 1954, placed restrictions on an investor's ability to maintain the same economic position under these circumstances, passing what is currently codified at 26 U.S.C. [section] 1091(a). (49) Commonly known as the "Wash Sale Rule," [section] 1091 prevents an individual investor (50) from deducting any loss that was sustained from the sale of a stock or other security if the investor purchases "substantially identical stock or securities" (51) within thirty days before or after the date of the sale. (52)

    It would appear that Congress solved the problem of an investor attempting to use the tax laws to harvest his losses, while also maintaining the same economic position in "substantially identical stock or securities." (53) However, neither Congress, nor the Treasury, nor the IRS (54) has sought to define either "substantially identical" (55) or "stock or securities," (56) which inevitably leads to ambiguity and fails to provide investors with a clear rule on which to base their tax planning efforts. Because shares of a given corporation would undoubtedly be substantially identical to shares of the same corporation, it seems relatively clear that an investor may not purchase a share of Corporation Y, sell Corporation Y for a capital loss, use that loss to offset his capital gains, and then repurchase a share of Corporation Y within thirty days in order to maintain his economic position. (57) Yet, as the financial vehicles available to investors for use in tax harvesting continue to become inherently more complex, (58) harvesting transactions often lack the clarity available in this simple example of buying and selling stock of Corporation Y.

  3. EXPLANATION OF EXCHANGE-TRADED FUNDS

    An ETF is one example of a complex investment vehicle that has "presented investors with new twists on an old plot, [specifically,] how to take advantage of loopholes in the wash-sale rule without running afoul of it." (59) Registered with the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940 (60) as "open-end[] funds" (61) or "unit investment trusts," (62) ETFs allow investors to enjoy a diversified investment through the "array of underlying securities" that comprise each ETF. (63) In turn, the underlying securities of each ETF will be indexed to specific "benchmarks--such as the S&P 500 Composite Price Index." (64)

    In terms of providing diversity, ETFs are similar to traditional (65) mutual funds, (66) with both investment funds "provid[ing] an investor with access to an array of underlying securities through a single investment." (67) There are some key distinctions, however, between these two types of investment funds that are important to the issue of taxation at hand. First, ETF shares (68) are traded on stock exchanges, just like shares of an individual corporation, with the price of the ETF shares constantly adjusting to meet market expectations. (69) In comparison, mutual funds are priced only at the close of each business day, (70)...

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