Wash Sales – What they are, and how to avoid them when implementing a Tax Loss Harvesting Program

March 8, 2023

We recently read how former Microsoft CEO and current owner of the Los Angeles Clippers Steve Balmer made the news for potentially violating IRS guidelines on how investment losses and gains are taxed. Balmer, with a net worth of roughly $81 billion, outsourced the management of his sizable investment portfolio to a large Wall Street bank. Unfortunately, trades executed by his investment manager in 2015 ran afoul of the ambiguous IRS guidelines covering wash sales.

Balmer’s investment manager sold a portfolio of individual stocks at a loss while simultaneously buying replacement securities. This is common practice for investors, in which stocks that are correlated (i.e., typically behave similarly, such as FedEx and UPS or Home Depot and Lowes) are temporarily swapped to book a loss that can be applied to offset other investment gains, while maintaining the overall portfolio’s sector and industry exposure. The process is commonly referred to as Tax-Loss Harvesting. The mistake made in Ballmer’s case was that the replacement securities he bought were the same companies he sold, just different share classes and stock tickers. In doing so, he violated the Wash Sale rule, and incurred back taxes and penalties.

What is the Wash Sale rule, and how did the world’s 8th richest man and one of the globe’s biggest investment banks make such an obvious mistake? Let’s examine the rule, what went wrong, and how an effectively implemented Direct Indexing program from Vestbridge can avoid such pitfalls.

The Wash Sale rule was created in the 1920s and defines a wash sale as one that occurs when an individual sells or trades a security at a loss and, within 30 days before or after this sale, buys the same or a substantially identical stock or security, or acquires a contract or option to do so. So using our earlier example of FedEx and UPS, an investor could book a loss by selling FedEx, replace the position with UPS, and then swap back in the FedEx shares after expiration of the 30-day cooling period. The investor can then use the loss from the original FedEx shares to offset gains from other investments. This approach is commonly utilized by high-net-worth investors to reduce their tax liability from often considerable investment gains.

The confusion surrounding the Wash Sale lies in the definition of “substantially identical”, which the IRS has never clearly defined. With the proliferation of index-based ETFs and mutual funds, it is possible to execute tax-loss harvesting by swapping one ETF or fund for another. The replacement fund may hold many of the same underlying positions, and some have argued that this constitutes “substantially identical” holdings, but the IRS has never clarified this rule and such trades are commonplace. So while the IRS has not explicitly endorsed tax-loss-harvesting using via similar ETFs and mutual funds, there is no record of the agency contesting such trades, which are extremely commonplace. The IRS continues to avoid commenting and therefore industry standard practice is to consider replacement funds or ETFs not “substantially identical” and therefore permitted.

In Ballmer’s case, the violation did not occur from ETFs or mutual funds, but individual stocks with multiple share classes. It is obvious that Shell PLC Class A (RYDAF) and Shell PLC Class C (SHEL) are “substantially identical”, being the same company despite having different tickers. However, the software used to harvest losses for Balmer clearly failed to make this distinction, as it implemented swaps using Shell and several other substantially identical stocks represented by different share classes.

The wash sale trades made in Ballmer’s account were part of a Tax-Loss Harvesting program which sheltered him from paying in at least $138 million in taxes over four years. For decades, the ultra-wealthy have used similar approaches to minimize taxes on their investment gains. But Ballmer’s mistake is a cautionary tale, since violating IRS regulations can “wash” away years of carefully planned tax mitigation strategy.

FinTech advances in recent years have opened up the potential benefits of Tax Loss Harvesting to a wider audience. At Vestbridge Advisors, we use a sophisticated, modern technology to create Direct Indexing model portfolios, which enable us to deliver to our clients a Tax Loss Harvesting strategy, among other benefits, that meets IRS guidelines. The Vestbridge Direct Index models are diversified portfolios which may hold US equities, International equities, and fixed income ETFs and/or mutual funds. Within the equity allocations, our clients own a representative sample of stocks that is designed to perform within a very tight tolerance of tracking error of the target asset class index. The stocks held in the client account are then continuously monitored for Tax Loss Harvesting opportunities. To prevent wash sale issues like those Mr. Ballmer unfortunately experienced, our representative pool of eligible securities are thoroughly screened to remove duplicate share classes. Our screening process goes even further, to ensure that our clients get best execution on trades by implementing liquidity requirement thresholds and other controls before the computer optimization even occurs.

Tax Loss Harvesting can be a powerful tool and potentially deliver index-beating returns, if implemented with care and scrutiny. At Vestbridge Advisors, we have gone to great lengths to make sure that our Direct Indexing program can capture tax benefits for our clients in a way that is mindful of the complexities inherent in the tax code. We also offer the ability to implement a tax-conscious approach for smaller client accounts using ETFs and Mutual Funds and can assist in transitioning existing client portfolios into one of our many model offerings in a tax-aware process.