Understanding and Implementing a Tax Loss Strategy

bee

A successful tax loss harvesting strategy should generate a tax loss in the short run without generating an actual monetary loss in the long run. What I mean by this is that you should never make it an explicit goal to lose money just for the tax benefits. Losing money is always bad for you as an investor. As Warren Buffett’s once said:

The first rule of investment is don’t lose. And the second rule of investment is don’t forget the first rule. And that’s all the rules there are.

However, a good tax loss harvesting strategy can generate losses as they appear without losing money in the long run. How does it do this?

First it sells a security at a loss, and then it takes the proceeds from that sale and buys an “alternate security” that behaves similarly, but not identically to the original security. Why does it purchase an alternate security? Because it wants to generate a tax loss without changing your exposure to the underlying asset class.

For example, let’s say you owned $10,000 of VWO (Vanguard FTSE Emerging Markets ETF) in a taxable account as of January 1, 2020. The optimal tax loss harvesting strategy would have sold your VWO on March 23, 2020 (i.e. the coronavirus bottom) to generate the largest tax loss possible, and then would have immediately taken the proceeds from that sale ($6,817) and bought shares of IEMG (iShares Core MSCI Emerging Markets ETF) to replace it.

tax-loss-harvesting

msf

For the most part, this is a solid, sensible piece, worth the read. However, one part, quoted below, gives me pause. The recommendation is solid, the representation of the tax laws, less so.

For example, while selling VOO (Vanguard S&P 500 ETF) to buy SPY (SPDR S&P 500 ETF) would definitely generate a wash sale, selling VWO (Vanguard FTSE Emerging Markets ETF) to buy IEMG (iShares Core MSCI Emerging Markets ETF) wouldn’t.

How do I know? Because Betterment, one of the domain experts on tax loss harvesting, lists IEMG as the security alternate for VWO in their taxable accounts.

While no sane tax advisor would suggest swapping VOO for SPY when harvesting a loss, Betterment like many professionals does not say that this is definitely a wash sale. Rather, Betterment writes:

Less clear is the treatment of two index funds from different issuers (e.g., Vanguard and Schwab) that track the same index. While the IRS has not issued any guidance to suggest that such two funds are “substantially identical,” a more conservative approach when dealing with an index fund portfolio would be to repurchase a fund whose performance correlates closely with that of the harvested fund, but tracks a different index.

https://www.betterment.com/resources/tax-loss-harvesting-methodology/#wash-sales

Fairmark (Kaye Thomas) writes:

Because there is no direct authority dealing with this question, reasonable minds may disagree. It’s always possible to identify differences between funds managed by different companies, such as expense ratios and tax load. Some people conclude on this basis that funds maintained by two different companies are never substantially identical.

My feeling is that those differences aren’t enough to prevent the two funds from being substantially identical. The point of the wash sale rule is to determine whether you’ve changed your position relative to the market. If you can lay the price graph for your new investment on top of the price graph for the old one and never see a significant disparity (as would be the case for two high quality S&P 500 funds), the investments should be considered substantially identical for purposes of the wash sale rule.

https://fairmark.com/investment-taxation/capital-gain/wash/substantially-identical-securities/

What's interesting is the choice of S&P funds. Forget about their ERs and tax efficiency. They have different structures; SPY cannot reinvest stock dividends as they are received. So while your exposure to equities remains relatively steady (near 100%) over time in VOO, it follows a sawtooth pattern in SPY. Equity exposure as a percentage of portfolio declines over the quarter as unreinvested dividends accumulate. Then they are distributed, and the fund is once again nearly 100% invested in equities. Is this enough to make a substantial difference? I wouldn't bet on it, but it is a clear distinction.

Derf

Question . Would the IRS vigorously pursue a tax lose of $3500 wash when the Trumpster wrote off $70,000 for hair cuts ? Or was I dreaming this !?

Stay Safe, Derf

msf

Yes, the IRS might vigorously pursue your small potatoes. For several years, though underfunded, the IRS has chosen to continue auditing low earners at the same rate while reducing the number of audits on high earners.
https://www.propublica.org/article/irs-now-audits-poor-americans-at-about-the-same-rate-as-the-top-1-percent

Apparently, the IRS doesn't "get" Willie Sutton. Banks may be harder to break into than a tenement, but the payoff still makes them the better target. Same for tax evaders.

In 1989, the real estate mogul Leona Helmsley was sentenced to four years in prison for tax evasion after she tried to write off improvements to her estate in Greenwich, Conn., as business expenses.

One of her lawyers was Alan Dershowitz, who defended Mr. Trump during the impeachment proceedings.

The United States attorney who brought the charges? Rudolph W. Giuliani, who appeared this week with Mr. Trump to denounce The Times’s reporting and has called Mr. Trump a “genius” for finding ways to shrink his tax bill.

https://www.nytimes.com/2020/10/06/business/trump-taxes-hair.html