Many investors find themselves sitting on losses due to deteriorating stock markets.  There is a lot of interest in taking those losses but also a reluctance to let go of the position for 31 days (as the wash sale rules would dictate).  Investors are worried that if they sell, they will miss the profits when the markets rebound. Oddly, the interaction of the relevant tax rules could allow an investor to “stay invested” in the market while still realizing their loss (while still following the wash sale rules).

Step One: Sell your ETF (or index fund) and realize your loss.  As an example let’s assume the investor has a $30 loss per share on the SPDR ETF that tracks the S+P 500.

Step Two: Buy a listed call option on the same index the ETF followed.  A call option purchased after a share sale is considered a wash sale transaction by the government.  The penalty is that the loss on the shares ($30 per share in our case) is not currently deductible, but instead is added to the cost basis of the call option purchased. If we pay $4 for the call, its cost basis is increased to $34.

Take care to buy an option on the index that is subject to IRC Section 1256. Section 1256 contracts must be marked to market on December 31st.  The mark-to-market on December 31 should trigger the realization of the investor’s loss for tax purposes.

Step Three: In the beginning of the following year the option could be sold and the ETF repurchased. As long as the option has not become very deep in the money, it should not be substantially identical to the ETF. Therefore, the wash sale rules should not apply to the loss recognized on the option.

Execution Fine Points

These options must be traded on an exchange.  Over-the-counter index options are not IRC Section 1256 contracts. Also make sure the call option is on the index itself, there are call options on the ETF too.  We are of the belief that an option on an ETF (vs. an option on the index) would not be an IRC Section 1256 contract.

Any mark-to-market gain or loss is taxed as 60% long term gain and 40% short term gain (causing a blended tax rate of 23%).  This 60/40 treatment would be an extra benefit to those with unrealized long-term losses and a detriment to those with unrealized short-term losses that could have created a 35% benefit versus a 23% benefit.

In short, by closely following the taxation rules on wash sales and Section 1256 contracts, an investor can harvest their losses on an ETF or open end Index Fund without disturbing their investment returns.