The financial markets have hit a rough spot in the road recently and the pullback has wiped out all of the January gains in the stock market. Concurrently, bonds have suffered as interest rates have risen. Many would argue that rising interest rates were the cause of the stock market drop. In any event, numerous investors are seeing losses “on paper” for at least a portion of their equity and fixed income holdings.
A prudent tax strategy is to occasionally “harvest” these losses so as to allow Uncle Sam to “share” some of the investment pain. Taxpayers can utilize realized losses on their tax returns to first, offset realized gains via a netting process, with any remaining loss then used to offset ordinary income, subject to an annual limit of $3,000. Any realized (and netted) losses exceeding this $3,000 annual limit are then carried forward to future tax years.
Mutual fund and ETF owners who reinvest dividends within taxable accounts, however, must also take an additional step prior to employing a tax loss harvesting strategy. This additional step would be to temporarily cease reinvesting any monthly dividends generated by the loss bearing mutual fund or ETF. This is due to an IRS regulation called the “wash sale” rule that applies to investment losses. In a nutshell, the “wash sale” rule precludes a taxpayer from utilizing a realized investment loss if the taxpayer has purchased a substantially equivalent investment during the 61 day period surrounding the date of the realized loss.
Since many bond mutual funds, as well as bond ETF’s pay dividends monthly, the process of reinvesting a declared dividend will represent a new purchase of the security in question. In turn, this action will usually run afoul of the “wash sale” rule. The same violation would take place if an equity fund dividend (more commonly paid quarterly) is reinvested during the 61 day window around the loss harvesting date. Thus, taxpayers looking to employ a loss harvesting strategy should be aware of this possibility.
There is a simple solution to this dilemma which is to temporarily suspend any dividend reinvestment process while within the 61 day window. Investors can either take the dividend in the form of cash or direct the dividend to a substantially different investment. What is a “substantially different” investment? While the IRS is not specific in its guidance here, most practitioners suggest an investment with different characteristics from the fund/ETF which was sold. Two bond funds/ETF’s with differing average bond maturities and durations are considered dissimilar, as would be two fixed income investments with very different credit quality profiles. Most actively managed stock funds would also be considered different. However, two different index funds which target the same benchmark, even if offered by two completely different investment management firms, are not considered substantially different.