Who: This post is for people who know what the wash rule is and do not like it. This post is also for people who are not opposed to investing in ETF’s and have at least a mild familiarity with them.
What: This is an intermediate level post about using Exchange Traded Funds (ETFs) to avoid the IRS’s wash sale rule.

Many people are currently filing their tax returns or have already done so. If you are involved in investing, you will know that Uncle Sam can hit you pretty hard for your capital gains. You may also know that you’re allowed to use your capital losses to offset your capital gains. You can even claim up to $3000 of capital losses to deduct from your taxable income.

Now, what people used to do was hold shares of a security and then sell it for a loss when it went down. This way they could deduct the capital loss on their taxes. The next thing they did was immediately buy back the same amount of shares and hold onto them (hopefully waiting for a rebound). If they held them past the end of the tax year, they may have made all their money back, but since the gains were unrealized (they didn’t sell the stock again) it was not counted as a capital gain. The IRS quickly put a stop to these shenanigans by implementing the wash sale rule. This rule states that you may not deduct a capital loss for a security if you purchase a substantially similar security within 30 days of the original sale. This stinks.

Enter ETF’s. ETF’s allow you to sell off positions for a loss and then purchase another ETF that is not “substantially similar” to allow yourself to recapture gains if you think they will come. This is an excellent strategy, as long as you do not abuse it. The IRS has yet to specifically define exactly what “substantially similar” means, so many people take it to mean different things. You may purchase an ETF from one issuer that tracks the Pharmaceutical sector and then sell it off. If you buy another ETF that tracks the exact same index AND is issued by the same issuer, you may not be able to duck the wash sale rule. However, if you select a different issuer and use a SLIGHTLY different index, you may be able to
get around the wash sale rule.

How does that work? If you sell your original ETF purchase for a loss, this allows you to claim a capital loss without actually cashing out of your position (because you are buying an ETF that is highly correlated with the one you sold, but is not “substantially similar”). You’ll want to make sure the securities you are selling and buying do not constitute “substantially similar” securities, and this may be difficult, but in general if you buy from a different issuer and have a slightly different market, you’re safe. Good luck, and don’t get too carried away.

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