Sunday, November 26, 2006

Successful Investing 101 – Taking Tax Losses and Avoiding the Wash Sale Rule

If you want to take a loss on a stock or mutual fund this year and own it again before next year, Monday and Tuesday are the last trading days to avoid the wash sale rule. The wash sale rule requires that if you sell a stock at a loss you must not buy substantial identical securities 30 days before of after the sale. If you do, the loss cannot be claimed.

Here’s a scenario where you may want to sell some losses, even though you still want to keep the stock. (For the purposes of this discussion, the term stock will refer to either stocks or mutual funds.) Because of some successful investing, you have made $5,000 on a stock that you have sold. This is good. However, another stock you are holding is down $5,000 and you expect it to go higher next year. If you do nothing you will pay taxes on the $5,000 gain.

If you sell the shares with a loss, your gain for the year will be zero, $5,000 gain minus $5,000 loss. The IRS will allow this. It would be great if you could buy back the stock the next day, thus taking the loss and still keeping the stock. However, the IRS does not allow you to buy back the stock within 30 days of the sale. Thus, there is risk the stock price may be significantly different when you buy it back.

Personally, I like to avoid paying taxes. So I try to sell as many losses as possible near year end. Often, it is an easy decision. There are stocks that I want to sell outright. (In November. I have already sold Axcan Pharmaceuticals (AXCA), AU Optronics (AUO ) and Chico’s (CHS) for a loss.) For those stocks that I want to continue to own next year, I manage them to avoid the wash sale rule.

I use a buy first and sell second strategy to avoid wash sales. Here are details on how strategy works:

Buy identified stocks in November. October and November are typically months when people do tax loss selling. Thus, the stock price is likely to be depressed in these months. I only had one stock with a loss that I wanted to keep next year, Genta (GNTA). I bought shares of GNTA on Friday, November 24, 2006.

Sell identified stocks in December after 30 days. For GNTA, I can sell shares for a loss anytime after December 24, 2006 and avoid the wash sale rule. My hope is that GNTA will rise slightly in December as people anticipate some good news in January, 2007 from their FDA submission.

If there is a sudden rise in GNTA, I will benefit from owning twice the number of shares. (I would be extremely disappointed if I had sold first and the rise happened during that time.) Of course, there are no guarantees. GNTA could go lower, creating more losses.

This is not financial, investing or tax advice. Please consult a professional advisor.

Copyright © 2006 Achievement Catalyst, LLC


Anonymous said...

Posted on Moomin Valley:

Seems you are assuming that because we didn't see weakness in September-October it's not going to happen. There was weakness in May-July but the Dow and S&P 500 did not make a 10% correction. Therefore, by the standard definitions the bull market that started in 2002 is ongoing and becoming one of the longest ever. The only bull markets longer than this one ended in 1962, 1987, and 1998 (saw this somewhere on with sharp crashes. This doesn't mean that this will happen again but that we shouldn't be too bullish just because the correction didn't occur in Presidential Year 2 yet. Another fact is that the yield curve remains inverted and getting more so. The 1987 and 1998 crashes did not result in recessions or major bear markets. The same outcome could occur here... or maybe not.

Friday BTW saw a jump up in the VIX and VXN volatiltiy indices... maybe suggesting that the decline in the US stockmarket wasn't just random noise? The model is very unclear here, so I'm not invoking it.

Anonymous said...

Just a random thought about capital gains taxes, and how you can avoid paying any capital gains... If you have an IRA, and if you are able to trade options within your IRA, there is a very simple way to avoid capital gains.

Step 1: Sell a deep in the money put just before options Ex. For example, sell a DIA Nov 140 Put and collect the large premium.

Step 2: Allow the Put to be assigned.

You will be forced to buy the stock at the inflated strike price, but that should off set by the extra premium that you got for selling the position.

Step 3: Have your brokerage house do a IRA Distribution in the form of the Shares from the assignment.

The cost basis is maintained from the distributed shares. So, since you sold the 140 strike options, your cost basis is 140 plus commissions.

Step 4: Sell the stock ASAP once the distribution happens in your taxible account. (Note, you could also avoid any possible drop in the stock by shorting the stock in your taxible account at the same time as you sell the put in your IRA)

Step 5: You have 60 days to return the funds from your distribution back to your IRA account.

Given this example if you had sold option for DIA at 140, and the going price is roughly 122, you would have a capital loss (on paper) of $18 per share. And since you distributed that loss position to your taxible account, you would be able to use that paper loss to off set any capital gains that you had in your taxible account through out the year.

The best part is that the IRS has no idea what happens in your IRA, including the premium that you got for selling the option. Since that position stays in your IRA, it is never identified as a wash sale. The same is true if you had bought stock in your IRA. You can distribute those shares to your taxible account, and sell them. Then turn around and re-deposit the proceeds into your IRA as a return of distributed funds, and buy the same stock back. Again NO Wash Sale since it happens in your IRA. The other good thing is that this whole process should only take a few days, as most brokerage houses have automated this workflow process.

Super Saver said...


Thanks for your comments and details of an approach that uses IRA funds to avoid wash sale rules. Very interesting.

I have read that using an IRA to avoid the wash sale rule is considered a gray area among proffessional tax advisors and financial advisors. Some agree the IRA is a non-taxed asset (until withdrawn) and therefore, not affected by wash sale rules. Others consider an IRA to be included in wash sale rules. Best advice is to consult a professional on the tax consequences for this type of transaction.

By the way, in your example, I think (but am not sure) the capital gain would eventually be taxed when the IRA funds were withdrawn. Would your example need to be done with a Roth IRA to completely avoid a tax on the gain?

Anonymous said...

The capital gain consequences are irrelevant in both a traditional and Roth IRA. The reason is that there is no distinction between funds in vs. funds out other than contributions that are put into a traditional IRA that were not tax deductible when they were put into the IRA. So all distributions at the time of retirement whether made up of contributions or capital gains (except non deductible contributions) are taxed at the tax payers normal tax rate. There are no capital gains taxes, just normal distributions. In a Roth IRA, there are no capital gains nor any regular taxes (best of both worlds). Although this may be a grey area, I have seen it at work and I have never heard of anyone being called to the carpet by the auditors for this behavior. I agree that anyone considering this tactic should consult their tax advisor, and especially ask them if the IRS has ever asked for any records from there IRA accounts.

Super Saver said...


Thanks for the clarifications and additional suggestions.