Exchange Traded Funds (ETFs) are the perfect investment vehicle to avoid the IRS’s Wash Rule. Let’s say you had a bad year on a particular investment or you had a bad year on many of your investments. Sell the investment(s) by December 31st and you can use the loss to offset any capital gains or, if you’ve had no capital gains, deduct the loss from your taxable ordinary income, up to $3,000.
But there’s a problem. Because of the IRS’s wash rule, you can’t sell an investment on December 31st and claim a loss if you buy back that same investment or any substantially identical investment within 30 days of the sale. You may simply want to leave the sale proceeds in cash. That way, you save on any transaction costs and avoid the hassle of trading.
On the other hand, January is historically a very good time for stocks. You may not want to be out of the market that month. What to do?
ETFs to the rescue!
ETFs are not substantially identical to individual stock
The IRS rules are a bit hazy when it comes to identifying substantially identical investments. Clearly, you can’t sell and then buy back the same stock. But if you sell $10,000 of Exxon Mobil Corp. (XOM) stock, you can buy $10,000 of an ETF that covers the energy industry, such as the Energy Select Sector SPDR (XLE) or the Vanguard Energy ETF (VDE).
They’re not the same thing, for sure, but either one can be expected to perform in line with XOM (and its competitors as well) for the 30 days that you must live without your stock. And rest assured, no ETF could reasonably be deemed to be substantially identical to any individual stock.
One ETF is not substantially identical to another ETF
Even if you keep most of your portfolio in ETFs and one year turns out to be especially bad for, say, large cap value stocks, no problem. If you are holding the iShares S&P 500 Value Index Fund (IVE) and you sell it at a loss, you can buy the Vanguard Value ETF (VTV), hold it for a month, and then switch back if you wish.
Two ETFs that track similar indexes are going to be very, very similar but not substantially identical. At least the IRS so far has not deemed them substantially identical. But the IRS changes its rules often, and what constitutes substantially identical could change tomorrow or the next day. It’s usually a good idea to consult with a tax professional before proceeding with any tax harvesting plans.
Consider cost before tax harvesting with ETFs
Trading an ETF may require you to pay a trading commission to a brokerage house. Harvesting a tax loss generally requires four trades. (Sell the original holding, buy the replacement, sell the replacement, buy back the original holding.)
If you’re paying $10 per trade, that adds up to $40. Plus, you lose a bit of money on each trade with the spread (the difference between the ask and bid prices on a security). If you are in the 25 percent tax bracket, your loss on a particular investment should be at least $250 or so before you should bother even to think about tax harvesting with ETFs.
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Source:http://www.dummies.com/how-to/content/etfs-and-tax-harvesting-steer-clear-of-the-irss-14.html
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