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).
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.
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
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.
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.
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
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
losses and a detriment to those with unrealized short-term losses
that could have created a 35% benefit versus a 23% benefit.
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