What is the wash sale rule on ETFs?
Q: How does the wash sale rule work? If you sell a security at a loss and buy the same or a substantially identical security within 30 calendar days before or after the sale, you won't be able to take a loss for that security on your current-year tax return.
Investors who buy a "substantially identical security" within 30 days before or after selling at a loss are subject to the wash-sale rule. The rule prevents an investor from selling a security at a loss, booking that loss to offset the tax bill, and then immediately buying the security back at, or near, the sale price.
Is a Wash Sale Window 30 or 60 Days? A wash sale is a total of a 60-day window—starting from 30 days before the sale to 30 days after the sale.
That means the tax hit from winning stock bets is postponed until the investor sells the ETF, a perk holders of mutual funds, hedge funds and individual brokerage accounts don't typically enjoy. The ETF tax loophole works only on capital gains, though.
A Wash Sale occurs if you sell securities at a loss and buy substantially identical replacement shares within 30 days before or after the sale. The Wash Sale Period is 30 days before and 30 days after the sale date, totaling 61 days (including the sale date).
To avoid a wash sale, you could replace it with a different ETF (or several different ETFs) with similar but not identical assets, such as one tracking the Russell 1000 Index® (RUI). That would preserve your tax break and keep you in the market with about the same asset allocation.
| Mutual Funds | ETFs | |
|---|---|---|
| Trades executed: | Once per day, after market close | Throughout the trading day and during extended hours trading |
| Settlement period: | From 1 to 2 business days | 2 business days (trade date + 2) |
| Short sales allowed? | No | Yes |
| Limit and stop orders allowed? | No | Yes |
Note: Wash sales are in scope only if reported on Form 1099-B or on a brokerage or mutual fund statement. Click here for an explanation. A wash sale is the sale of securities at a loss and the acquisition of same (substantially identical) securities within 30 days of sale date (before or after).
Keep in mind that the wash sale rule goes into effect 30 days before and after the sale, so you have a 61-day window to avoid buying the same stock.
To avoid a wash sale, the investor can wait more than 30 days from the sale to purchase an identical or substantially identical investment or invest in exchange-traded or mutual funds with similar investments to the one sold.
Do wash sales apply to ETFs?
ETFs can be used to avoid the wash sale rule while maintaining a similar investment holding. This is because ETFs typically are an index for a sector or other group of stocks and are not substantially identical to a single stock.
One common strategy is to close out positions that have losses before their one-year anniversary. You then keep positions that have gains for more than one year. This way, your gains receive long-term capital gains treatment, lowering your tax liability.
At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.
Generally, the wash sale rule applies to traders the same way it applies to investors. The difference is that traders have a much harder time keeping records relating to wash sales because they engage in so many transactions. There is a way for traders to escape the wash sale rule altogether.
DEFG shares and shares of its closest competitor, PQRS, would probably not be considered substantially similar, so you can trade within a given industry to help avoid wash-sale problems. So, if you are going to do some “day trading,” be very aware of this rule and keep meticulous records.
The $3,000 loss limit is the amount that can be offset against ordinary income. Above $3,000 is where things can get complicated.
Suspicious trading patterns: If you notice that the same investor is buying and selling an asset at the same time, or if a group of investors are all buying and selling an asset amongst themselves, it could be a sign of wash trading.
ETFs are traded in the markets during regular hours, just like stocks are. Mutual funds can be redeemed only at the end of a trading day. Stocks are traded during regular market hours.
The IRS will disallow your loss, and you won't be able to claim a write-off on your tax return. You'll end up owing taxes on any income that you tried to offset with your wash sale.
Since ETFs are traded on the stock exchange, they can be bought and sold at any time during market hours like a stock. This is known as 'real time pricing'. In contrast, mutual funds can be bought and redeemed only at the relevant NAV; the NAV is declared only once at the end of the day.
What is the best day of the week to buy ETFs?
One of the most popular and long-believed theories is that the best time of the week to buy shares is on a Monday. The wisdom behind this is that the general momentum of the stock market will, come Monday morning, follow the trajectory it was on when the markets closed.
ETFs may close due to lack of investor interest or poor returns. For investors, the easiest way to exit an ETF investment is to sell it on the open market. Liquidation of ETFs is strictly regulated; when an ETF closes, any remaining shareholders will receive a payout based on what they had invested in the ETF.
For positions where you still own some shares, you can recover the disallowed loss by selling all the shares that you still own, and not purchasing any shares of the same stock for at least 30 days after the sale.
While in the short-term, they may avoid the wash sale loss problem, over the long-term, it will not work out well for the brokers or the clients. The IRS will probably audit some of their clients over wash sales and agents will likely propose tax changes, including tax liability, penalties and interest.
The tax benefit of your capital loss isn't gone forever, but it's deferred. The loss on the original investment will be taken into account when you sell your replacement shares by applying the losses to your adjusted cost basis.
