TSC Tax Forum

Return to Article

When Exchange-Traded Fund Sales Wash, Does the IRS Supply Towels?

Tracy Byrnes

Since exchange-traded funds like the Standard & Poor's Depositary Receipts (Spiders), the Nasdaq 100 tracking stock QQQ (QQQ Quote - Cramer on QQQ - Stock Picks) and the lineup of iShares indices from Barclays Global Investors, trade just like stocks, many investors are flipping them more frequently than they would regular mutual funds.

If you're one of these fast-trading investors, you need to be more aware of the infamous wash-sale rule than if you were a buy-and-hold fund owner. The wash-sale rule says that if you sell a security at a loss and buy a "substantially identical" security within 30 days, the loss is disallowed for tax purposes.

So if, for example, you buy Cisco on Monday and sell it at a loss on Tuesday, the wash-sale rule says you can't claim that loss if you buy back Cisco shares within 30 days.

How does the wash-sale rule come into play with exchange-traded funds, also known as ETFs?

Let's say all your technology holdings have tanked recently, but you still believe in the sector. You sell some of your tech stocks to generate losses for tax purposes and buy the Technology Sector Spider (XLK Quote - Cramer on XLK - Stock Picks) so you can continue to have tech exposure. Those products are not substantially identical -- on the one hand you have stocks; on the other, an index -- so you have no wash-sale rule worries.

But what if you sell an exchange-traded fund that's losing money and buy another exchange-traded fund?

If the underlying portfolios are different, you're in the clear. You can sell, say, the iShares Dow Jones Utility index (IDU Quote - Cramer on IDU - Stock Picks) at a loss and buy the Dow Jones U.S. Chemicals index (IYD Quote - Cramer on IYD - Stock Picks) within 30 days without having to worry about the wash-sale rule. There is no portfolio overlap, and these products clearly are not substantially identical.

But what if you buy the S&P 500 Spider (SPY Quote - Cramer on SPY - Stock Picks), sell it at a loss and buy the iShares S&P 500 index (IVV Quote - Cramer on IVV - Stock Picks) the next day? Or what if you want to sell the (VFINX Quote - Cramer on VFINX - Stock Picks)Vanguard 500 Index, a traditional mutual fund, at a loss and buy the Spider? Are those products substantially identical? Will those transactions invoke the wash-sale rule?

Here, the answer is not clear. Some experts say the wash-sale rule is not an issue. Others are more cautious and say it might be. But due to a continual lack of guidance from the Internal Revenue Service, it becomes your call.

Let's look at the case on both sides of the question.

(By the way, HOLDRs, another type of exchange-traded fund, fall under their own set of rules. For more, see this previous Tax Forum.)

Don't Sweat It

"As long as the funds have different managers and fee structures, they may not be considered substantially identical," says Diane Garnick, equity derivatives strategist at Merrill Lynch, who recently issued a report on the topic. So Spiders and iShares, each tracking the S&P 500 index, would not be substantially identical, according to Garnick, because they have different fee structures and are run by different management companies.

The same would hold true if, say, you sold the Technology Sector Spider at a loss and invested in the Dow Jones U.S. Technology Sector index (IYW Quote - Cramer on IYW - Stock Picks).

The theory also would apply if you sold a traditional index-based mutual fund, like the Vanguard 500 index, and bought Spiders, says Garnick.

What's the logic behind this argument? "Since management is different and the expenses are different, your returns on the two products will therefore be different, even if the underlying vehicle has the same goal and objective," says Joel Dickson, a tax efficiency expert in Vanguard's portfolio review group. "We advise our clients that it's OK" to take a tax loss when moving between these types of funds.

"Different corporation, different fee structure -- until there's a ruling, I think you can do it," says Jim Calvin, an investment management tax partner at Deloitte & Touche in Boston.

That's the problem. There's no IRS ruling. These experts' conclusions are derived from older court cases in which two corporations were not considered substantially identical.

Be Careful Out There

But if these funds just mirror their respective indices and have the same objectives, where's the management?

The manager "is bound to always invest in proportion to the index. So there's no difference in the underlying holdings, regardless of the [management] company," says Robert Willens, a managing director and strategic tax guru at Lehman Brothers in New York.

Richard Shapiro, an Ernst & Young securities tax partner, agrees. "The methodology and the weightings must be different" in order to get around the wash-sale rule. "It's more than just management and fees."

Would he sign a tax return that assumes the wash-sale rule doesn't apply? "I'd think real hard about that," he says.

The key to avoiding the wash-sale rule, say these more cautious tax experts, is that your economic situation has to change from one investment to another. But "with the Spider, you own an underlying interest in each security in the S&P -- same goes for Barclays [iShares], so your economic position has not changed," says Willens.

Selling the Spider at a loss and buying S&P 500 iShares would indeed invoke the wash-sale rule, say these experts. So would selling Vanguard's S&P 500 fund at a loss and buying the Spider.

If the underlying securities are identical, it's hard to see how the indices themselves can't be substantially identical, says Willens. "I wouldn't even think of recommending such a strategy."

You Decide

Since there is nothing written in the IRS tomes to help us decide which theory is correct, the ball is in your court.

"Ultimately, the taxpayer is the one that has to justify the transaction if it's in question," says Dickson.

Think it through. As with most things, whether two securities are substantially identical ends up being in the "eye of the beholder," says Calvin. Whatever you decide, just be sure you can support your decision.

Send your questions and comments to taxforum@thestreet.com, and please include your full name. Tax Forum appears Tuesdays, Thursdays and Saturdays.