When Exchange-Traded Fund Sales Wash, Does the IRS Supply Towels?
By Tracy Byrnes
Senior Writer
8/17/00 2:54 PM ET
Since exchange-traded funds like the Standard & Poor's Depositary
Receipts (Spiders), the Nasdaq 100 tracking stock QQQ (QQQ:Amex -
news) 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:Amex - news) 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:Amex - news) at a
loss and buy the Dow Jones U.S. Chemicals index (IYD:Amex -
news) 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:Amex - news), sell it at
a loss and buy the iShares S&P 500 index (IVV:Amex - news) the next
day? Or what if you want to sell the 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:Amex - news).
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.
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