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Webinar Takes Deep Dive into Wash Sale Rule
Thursday, October 8, 2015
Come 2021, the wash sale rule will turn 100 years old. Longevity has not made it any easier to apply this rule to securities transactions and accurately compute taxable gains and losses. Why? Poorly-defined terminology included in section 1091, namely “substantially identical” securities and the increased use of some of the most complex financial instruments, including options and other derivatives.
To help demystify some of the complexity behind the wash sale rule and respond to feedback from past webinar attendees, on September 30th we re-presented Wash Sales: A Closer Look, our in-depth webinar on section 1091.
Thank you to our many attendees -- tax managers, compliance officers, tax analysts, controllers, chief financial officers and accountants from hedge funds, hedge fund service providers and accounting & audit firms -- for participating in this wash sale event. We are happy to report that 73% of our attendees earned CPE credit.
In general terms, a wash sale exists if you hold a loss position, dispose of it and use a replacement transaction to re-establish the same or (sufficiently similar) position within 30 days before or after the sale. The wash sale rule is one of several sections of the IRC that’s involved in performing tax accounting / analyses of securities transactions (TAST) and calculating taxable gains and losses on investments. TAST technology is used to help generate book to tax adjustments for end-of-year compliance purposes; in addition, when run during the year, it supports a tax-aware investing strategy.
Our resident TAST experts, Daniel Tilkin and William Fang, G2 FinTech's Tax and Business Analysts respectively, led this advanced wash sale webinar. They addressed so-called “wash sale headaches” – chaining, branching / lot depletion, substantially identical and contracts & options to acquire; they also discussed options and tax-aware investing. Mr. Fang and Mr. Tilkin used a variety of examples of trading activity to illustrate each of these concepts and saved time for a Q&A session.
Mr. Fang discussed the history behind the wash sale rule, which only applies to losses and was introduced in 1921 to discourage taxpayers from using tax-loss harvesting (TLH) to avoid taxes. TLH involves selling securities at a loss to offset a capital gains tax liability. A popular way to reduce an investor’s tax liabilities, TLH typically limits the recognition of higher short-term capital gains.
Mr. Fang went on to talk about chaining, which prevents taxpayers from avoiding the wash sale rule by simply selling the replacement lot to harvest the deferred loss. Without chaining, a taxpayer can simply execute a second set of buy/sell trader orders to harvest losses. Mr. Fang also explained that chaining adds to the complexity of the wash sale rule because it can cause the effects of wash sales to hop from one lot to another. This in turn affects the holding period, basis and calculation of gain/loss for each lot. He noted that a wash sale can extend over several years and the importance of tracking the cost basis adjustments for the life of a chain and that chains can affect and be affected by other cost basis altering events, including corporate actions and constructive sales.
Branching / Lot Depletion
Disposed and replacement lots do not always contain the same security size. Branching deals with replacement lots that are larger than the original/disposed lot. Mr. Fang explained that branching causes “sublots,” which should be treated as if they were acquired with separate and distinct trade activity than the replacement lot from which they were derived. He also mentioned how a prospective wash sale (a disposition showing a taxable loss) can be a candidate for wash-sale disallowance. Mr. Fang also discussed lot depletion, the inverse of branching. With lot depletion, when the original lot is larger than the replacement lot in a wash sale, the taxpayer needs to track the extent to which the lossy lot has been replaced. Mr. Fang noted that taxpayers must be consistent in their use of retirement algorithms when calculating wash sales.
Substantially Identical: A Poorly Defined Term
Taxpayers can use substantially identical (SI) securities as a replacement type in a wash sale. But what makes one security SI to another security? Mr. Tilkin noted that the term is not defined in the tax code, and it has been left to the courts and the IRS to determine what is and is not SI. Substantially identical has been referred to as the “elastic weasel word” meaning its definition can expand or contract depending on taxpayer whim. He explained how feature comparison (via the seminal Hanlin v. Commissioner appellate court decision) can be used to determine if securities are SI. If the two securities are not substantially different in any material (as related to bonds: issuer, maturity, interest rate) feature, then they are substantially identical. Mr. Tilkin also brought up Revenue Rulings 58-201 & 211, which demonstrate and augment Hanlin.
In his discussion of substantially identical, Mr. Tilkin shared some insight into how the tax code can be purposely vague. For instance, a 1921 definitive definition of SI would not account for future, new, and different securities (swaps, bonds with different options) that have come into existence and could be used to bypass the wash sale rule.
Contracts & Options to Acquire
Taxpayers can also use contracts and options (something introduced post 1921) to acquire substantially identical securities as part of a replacement type in a wash sale. For example, call options will always trigger a wash sale when stock is sold at a loss. Rights, warrants, and convertible securities are considered options to acquire for this purpose (RR 56-406 and 77-201). When discussing options wash sales, Mr. Tilkin noted that selling an option at a loss and acquiring stock is generally OK. However, he warned that in cases where the strike price is negligible, the option may be considered to be substantially identical to stock (56-406 – Warrants). Mr. Tilkin also pointed out that these same guidelines apply when the option’s underlier is substantially identical to the original security.
Options and Tax-Aware Investing
Before the Q&A session, Mr. Tilkin brought up the topic of options and tax-aware investing and discussed different trading transactions that would and would not trigger a wash sale. For instance, the taxpayer must recognize losses if they sell stock at a loss, and buy an out-of-the-money call option, triggering a wash sale. If they buy the position back, either selling the option, or letting it expire, that is not a wash sale.
Given the complexity involved in determing when securities are SI to one another, it's not surprising that the Q&A session involved questions on this topic. Are companies with two classes, one with voting rights and one without SI? What about securities and an ADR on the security? Mr. Tilkin effectively fielded these and other questions.
We hope attendees found the webinar informative and helpful. For those unable to attend or if attendees wish to review some of this very complex subject matter, a recording and pdf of the slide presentation will be available on our website. Please click here to access them. Our YouTube channel will feature this video soon. Video clips / mini-tutorials on the wash sale rule are currently available on our YouTube channel.
Upcoming Webinar on Tax-Aware Investing
Our next webinar, Tax-Aware Investing will take place on November 18th. In one hour learn how running tax analyses of securities transactions throughout the year can alert investment managers to the tax implications of their trading and make it possible for them to make the necessary trading adjustments in order to optimize after-tax returns. You can read more about tax-sensitive investing and its power in our blog "Tax Alpha and the When Factor."