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June 02, 2008

Avoiding Wash Sale Rule with Alternate Accounts
by Richard Shaw

Summary:

In the words of Tony Soprano: "Fogetaboutit".

Expanded Summary:

In the words of the IRS: "Section 1091", "Section 267" and "Rev Ruling 2008-5"

Purpose:

All investors and their investment advisors, should have an understanding of the Wash Sale Rule and related rules before making investment decisions, instead of learning about them painfully from their accountants at tax filing time.

This article is about where we stand as investment advisors on the important Wash Sale Rule with respect to schemes to circumvent the 30-day exclusionary period with alternate investment accounts such as:

IRA accounts
401-k accounts
other self directed tax qualified accounts
sole owner limited liability companies
sole owner S or C corporations
revocable living trusts
marital joint taxable accounts
spouse's individual taxable accounts
children's accounts

Disclaimer:

This article is for discussion purposes only and is not personal or specific "tax advice". We are investment advisors, not tax accountants, tax lawyers or tax advisors, but we are able to read, and the reading seems clear. You should read the IRS materials and draw your own conclusions, or rely on the guidance of your personal tax advisor.

Discussion:

The Wash Sale Rule contained in IRC Section 1091 says that an investor (who is not a dealer) cannot deduct the realized loss on investment if the investor made a "substantially identical" investment within the 30-day period before or after the date of the realized loss.

We wrote about whether or not substitute investment funds are "substantially identical" in two prior articles (August 11, 2007 and May 20, 2008).

"Substantially identical" is not defined in the regulations, but general consensus could probably be found with something like:

Substantially identical means the same in all important respects, particularly economic position and risk exposure, but not correlation of return, except for the case of two companies undergoing merger or the case of one security convertible to another.

This article discusses the use of multiple accounts of different types in relation to the Wash Sale Rule.

Rev Ruling 208-05: The most common alternate account scheme involves harvesting a loss in a regular taxable account, immediately buying the same security in an IRA (and perhaps then 31 days later closing the IRA position followed by re-opening the position in the regular account).

Blogs and forums have many references to this approach. The general responses to questioners are essentially "maybe that would work, and probably the IRS wouldn't find it" or "it probably doesn't work".

The IRS dealt with that scheme in January of 2008 with Revenue Ruling 2008-05, which flatly closes the door on the approach.

Key language from that ruling is as follows:

"ISSUE
If an individual sells stock or securities for a loss and causes his or her individual retirement account or Roth IRA to purchase substantially identical stock or securities within 30 days before or after the sale, is the loss on the sale of the stock or securities disallowed?"

"HOLDING
The loss on the sale of stock is disallowed under § 1091."

There are no current reporting requirements in place for taxpayers, brokers or fund companies to assist the IRS in finding Wash Sales involving an IRA, but we do not recommend tempting fate. We've all been put on notice by the Revenue Ruling. Someday, we may find one more new form to complete at tax time to deal with that issue.

One might argue that the IRA (or any other tax qualified account) changes the economic position and risk exposure of the investor by converting all gains and dividends to ordinary income, and by making capital losses within the IRA non-deductible. However, we've got better things to do than to argue with the IRS about that, and probably so do you.

Bottom line, you cannot use an IRA of any kind to circumvent the Wash Sale Rule.

The ruling does not say, but surely an IRS auditor would likely take the position, that use of a 401-k or other self-directed retirement plan to substitute a substantially identical holding is also not an acceptable way around the Wash Sale Rule.

Side Note: An interesting question might arise if an employee was making regular monthly purchases of employer stock in a 401-k, while also holding shares in the employer's company in a taxable personal account, and selling some of those taxable account shares at a loss. It seems that it would be disallowed by the logic of the ruling, but it also seems to be a quite different set of facts and circumstances. Perhaps there may be a ruling on that someday too.

Section 267: Related Party Transactions: Other wash sale avoidance schemes might involve harvesting a loss in a regular account and immediately buying the same security in a trust for which you are the beneficiary, or in a solely owned LLC or an S or C corporation, or in a joint marital account, a spouse's individual account or a child's account. Well - "Fogetaboutit".

Section 267 says,

"You cannot deduct your loss on the sale of stock through your broker if, under a prearranged plan, a related party buys the same stock you had owned."

We're not exactly sure what the larger term "pre-arranged means", but we are comfortable that it includes intentionally selling security "A" in controlled account XYZ and purchase of security "A" in controlled account ABC within the 30-day exclusionary period before and after the sale of security "A" in account XYZ, where you or your family benefit by both accounts.

There may or may not be some alternate structure that you can identify that the Related Party Rule of Section 267 does not specifically list, but the intent of the IRS is clear - If you control both accounts and benefit from both accounts, or the nature of the transaction is intra-family, they are related parties and you can't use them to avoid the Wash Sale Rule.

Conclusion:

Unless you find good sport in baiting the IRS and spending your time and money arguing points with them or the tax court, be satisfied that there is no way around the Wash Sale Rule with alternate accounts.

Perhaps someone with a mega-loss and mega-wealth will find good occasion to challenge some aspect of these rules, but if you lose hundreds, thousands or even tens of thousands of dollars, your time and money is better spent seeking similar, but not substantially identical, substitute investments in the same account where you incurred the loss. We discuss working rules for viable substitutions in another article.

Richard Shaw
QVM Group LLC