Loss Harvesting – Beginner to Expert

Every year about this time money managers and tax professionals start to hear from investors about impending capital gains and the need for offsetting capital losses. Below is a list of transactions ranging from simple to highly complex for use in recognizing the sought after losses. But before we dive in I must implore upon you – don’t wait until November or December to harvest losses. Start in January! It’s a process that should occur all year long. Losses will appear and disappear throughout the year in almost all portfolios. As they appear you should think about harvesting them early, even if you don’t currently need them. Individuals are able to carry capital losses forward indefinitely, as are mutual funds, so there is no harm in taking them when you see them.

Which method of loss harvesting is best depends on several variables including: (i) Does the taxpayer want to continue to own the asset; (ii) How liquid is the market for the underlying asset; and (iii) The price volatility of the underlying asset. If the taxpayer has a built-in loss on a liquid asset which is no longer needed / wanted in the taxpayer’s portfolio then the answer is simple – just sell the asset and recognize the loss. If the underlying asset is less liquid or the taxpayer does not want to dispose (or cannot dispose) of the asset the choices become more complex.

Most of the complexity stems from something called the “wash sale rule”. Under Section 1091 of the Internal Revenue Code and its regulations, any loss from the sale of a security is disallowed where the taxpayer purchases (or enters into an option to buy or contract to acquire), “substantially identical” securities within 30 days before or after the sale date (i.e., a 61-day period). The disallowed loss is added to the basis of the repurchased securities. Thus, selling IBM stock at a loss on December 5^th and repurchasing it on December 10^th of the same year will produce a wash sale and the December 5^th loss amount will not be currently deductible but rather the loss amount will be added to the tax basis of the IBM stock purchased on the 10^th.

So, if an investor or fund manager owns a security trading at a loss and wishes to harvest the loss for tax purposes without significantly altering the portfolio what options exist? If the exact name in the portfolio is not critical the answer is simple – sell the security at a loss and immediately replace it with something similar (at least for 31 days and then the exact security can be replaced into the portfolio if desired). Perhaps the entire technology sector is depressed and the investor sells the tech names in the portfolio for a loss and buys a technology ETF that represents the sector. Note, even if the exact names sold at a loss are present in the ETF, the transaction will not be a wash sale. Although exact replication in exact proportion may in fact trip the wash sale rules (e.g., a sale of an S&P index ETF of one company and purchase of another S&P index fund from a different ETF company is likely a wash sale). Additionally, in this world of ETF proliferation, it should be noted that many of the commodity ETFs are actually grantor trusts for tax purposes and the wash sale rules do not apply to commodities (investors are free to buy and sell intra-day to produce a tax loss). The wash sale rules also do not apply to foreign currency.

Many times however the investor or fund manager has a much more specific view and the exact stock or stocks in the portfolio are seen as critical and exposure to the specific security cannot be absent for even a day. In that case we need to get more creative. Below are several techniques to address this situation:

Trade Example: On January 1, 2013, the Investor bought 100 shares of XYZ at $100 per share (Block 1). XYZ is now trading for $60, so there is a $4,000 unrealized capital loss. Today, the Investor buys 100 more shares of XYZ at $60 (Block 2). After 31 days, the Investor can sell Block 1 and realize a loss at that point. The loss recognized will vary with the stock price after the 31 days. In the alternative, the Investor could also double-up with the purchase of call options.

Economic Risk: Twice the exposure for 31 days.

Tax Analysis: The Investor can specifically identify which block of shares is sold in a given transaction.

Trade Example: On January 1, 2013, the Investor bought 100 shares of XYZ at $100 per share (Block 1). XYZ is now trading for $60, so there is a $4,000 unrealized capital loss. Today, the Investor buys 100 more shares of XYZ at $60 (Block 2) and sells a call option on 100 shares of XYZ. The call option sold is structured to be a qualified covered call (“QCC”) under the straddle rules. The strike and maturity of the call option are chosen to meet the Investor’s risk preferences. After 31 days, the Investor can sell Block 1, repurchase the call option and realize a loss at that point. The loss recognized will vary with the stock price and option price after the 31 days.

Economic Risk: Between one and two times the exposure for 31 days. The Investor can sell extra call options in order to bring their initial delta as close to one as possible.

Tax Analysis: The Investor can identify which shares are sold in a given transaction. QCCs are not straddles and losses on them can be recognized before gains on offsetting positions, as long as the offsetting position remains unhedged for 30 days.

Caution: Larger Straddle Rule – If the Investor had increased his exposure by buying calls instead of stock, the written calls may not be QCCs. QCC status does not apply to options that are considered part of a larger straddle, which in this case could include the purchased calls. See Rev. Rul. 2002-66 where covered calls that were written along with the purchase of puts were ineligible for QCC exception to the straddle rules. In such a case any excess loss realized on closing out the written call position may be deferred under the straddle rules to the extent of the unrealized gain on the purchased call. Also, losses arising from straddle transactions may be subject to special rules for “reportable transactions.”

Trade Example: On January 1, 2013, the Investor bought 100 shares of XYZ for $100. XYZ is now trading for $60, so there is a $4,000 unrealized capital loss. Today, the Investor sells the shares of XYZ at $60 and sells a put option on 100 shares of XYZ struck at $72 for $14. Upon the sale of the stock, the Investor should recognize the $4,000 loss. The strike and maturity of the puts are chosen to meet the Investor’s risk preferences. After 31 days, the Investor can repurchase the put option and the stock. Depending upon the option price at that time, the Investor may recognize a gain or loss on the option.

Economic Risk: Somewhat less than one times the exposure for 31 days, depending upon the delta of the put options. The Investor can sell extra put options in order to bring their initial delta as close to one as possible.

Tax Analysis: Under Revenue Ruling 85-87, if there is a “substantial likelihood” that the put options will not be exercised, the sale of the puts should not trigger the wash sale rules. Investor will need to consult with their advisors regarding the amount by which the option can be struck in-the-money and not considered to be to be “substantially likely” to be exercised. Factors to consider in this determination include strike price, maturity of the option contract and the underlying volatility of a particular stock.

Trade Example: On January 1, 2013, the Investor bought 100 shares of XYZ for $100 (Block 1). XYZ is now trading for $60, so there is a $4,000 unrealized capital loss. Today, the Investor buys 100 shares of XYZ at $60 (Block 2), sells a call option on 100 shares of XYZ and buys a put option on 100 shares of XYZ. The put and the call should have different strikes. The options have maturities of at least 32 days. The strikes and maturities of the options are chosen to meet the Investor’s risk preference. Prior to the options expiration, and at least 31 days after the additional shares were purchased, the Investor can sell Block 1, cash settle the options and then recognize the loss. The loss will equal $4,000 if the stock is still trading at $60 and the options have not moved in value.

Economic Risk: Close to one times the exposure during the life of the options.

Tax Analysis: Under the wash sale rules (particularly Treas. Reg. Sec. 1.l091-1(g)), a short sale is treated as closed out when entered into. Therefore, if the Investor had sold XYZ short, instead of entering into the options trade, the wash sale rules would disallow the loss. The options, however, should not be construed as a short sale. Consequently, the wash sale rules should not disallow the loss on the sale of Block 1. Note, any loss resulting from Block 1 and the options will be subject to the straddle rules to the extent of the unrealized gain on Block 2. See Revenue Ruling 2002-66, whereby even if the calls are otherwise qualified in terms of maturity and not being deep-in-the-money, the existence of the put renders the positions part of a “larger straddle” and thus, the calls would not be considered qualifying for the QCC exception to the straddle rules. It’s also worth noting that the straddle will toll the stock’s holding period for purposes of qualified dividend income. Moreover, losses arising from straddle transactions may be subject to special rules for “reportable transactions.”

Trade Example: On January 1, 2013, the Investor bought 100 shares of XYZ for $100 (Block 1). XYZ is now trading for $60, so there is a $4,000 unrealized capital loss. Today, the Investor sells the 100 shares of XYZ at $60, and buys a call option on XYZ struck at $60 (with a term greater than 31 days). After 31 days, the option is sold and Investor acquires 100 shares of XYZ at market price (Block 2).

Economic Risk: The number of options purchased can be adjusted to bring the initial delta as close to one as possible.

Tax Analysis: The initial sale of stock followed by the purchase of a call option is a wash sale, with the disallowed loss added to the basis of the call option. The purchase of Block 2 should not be considered substantially identical to the call option (assuming the call is not deep in the money). The subsequent sale of the call option should allow the loss to be recognized at that time. Note that as a technical matter, this transaction should be able to be accomplished in four days or less. That is, the option can be purchased on day 1, stock sold on day 2, replacement stock purchased on day 3 and option sold on day 4. If this short-term strategy is employed it may be helpful to utilize two trading accounts. If executed in a single account the normal reporting systems of the broker will likely pick up the sale of Block 1 and purchase of Block 2 inside the 61-day period and report it to you as a wash sale (i.e, it reports the wrong wash sale). In addition, losses arising in transactions where the tax basis is not determined solely by reference to the amount paid in cash may be subject to special rules for “reportable transactions.”

Trade Example: On January 1, 2013, the Investor bought 100 shares of XYZ for $100 (Block 1). XYZ is now trading for $60, so there is a $4,000 unrealized capital loss. Today, the Investor sells the 100 shares of XYZ at $60, buys a 3-year call option on XYZ struck at $66 and sells a 3-year put option struck at $54 (20% band around the market price). After 31 days, the options are unwound and 100 new shares of XYZ stock are purchased (Block 2). At this point, the $4,000 loss is realized, assuming the stock is still trading at $60 and the options have not moved in value.

Economic Risk: The number of options entered into can be delta adjusted to result in a risk profile very close to one times the exposure during the life of the options. For example, a reverse collar on 125 shares of XYZ may approximate exposure to 100 shares of XYZ.

Tax Analysis: The initial sale of stock followed by the purchase of a call option is a wash sale, with the disallowed loss added to the basis in the call option. The subsequent sale of the call option and purchase of Block 2 should not be a wash sale, so any loss is recognized then. A sufficient spread in strikes of the options should avoid characterization of the options as substantially identical to the stock. In addition, losses arising in transactions where the tax basis is not determined solely by reference to the amount paid in cash may be subject to special rules for “reportable transactions.”

Trade Example: On January 1, 2013, the Investor sold short 100 shares of XYZ for $100. XYZ is now trading for $140, so there is a $4,000 unrealized short-term capital loss. Today, the Investor buys 100 shares of XYZ at $140 to cover, and buys a put on 100 shares of stock. The Investor should be able to recognize the short-term capital loss at that time.

Economic Risk: Less than one times the exposure.

Tax Analysis: While the wash sale rules apply to short sales replaced by another short sale on substantially identical securities, they do not apply to a short sale replaced with a long put position. If a long put is not too far in-the-money it should not be considered analogous to a short sale.

Trade Example: On December 15, 2013, Investor identifies a sub-portfolio of positions within its larger portfolio where each position is trading below its historic tax basis. The Investor is also interested in adding economic exposure to other positions. Investor sells the sub-portfolio at a loss and enters into a total return swap on a basket that includes both the liquidated sub-portfolio and the desired additional positions.

Economic Risk: One times the exposure of the liquidated portfolio plus the full exposure of the additional positions.

Tax Analysis: As long as the basket is properly constructed, it should not be considered substantially similar or related property (“SSRP”). See Treasury Regulation Section 1.246-5. SSRP is a more liberal standard than the “substantially identical” test for the wash sale regulations, and as such, the swap should not be deemed a wash sale vs. the sale of the stock portfolio.

Trade Example: On January 1, 2013, the Investor bought 100 shares of XYZ for $100 (Block 1). XYZ is now trading for $60, so there is a $4,000 unrealized capital loss. Today, the Investor sells the 100 shares of XYZ at $60, and enters into a total return equity swap on XYZ with an initial price of $60 and a term of one to twelve months. Investor terminates the swap post year-end and immediately acquires 100 shares of XYZ at the then market price.

Economic Risk: One times the exposure.

Tax Analysis: The sale of the stock and entering into the total return swap will trigger the wash sale rules and the embedded loss is added to the basis of the swap. If Investor has elected to mark its swaps to market pursuant to Prop. Treas. Reg. Section 1.446-3(i), the swap contract will automatically mark-to-market at year end and the embedded loss will be recognized. Note, a side effect of this method is that it transformed a capital loss to an ordinary loss which can be helpful.

Trade Example: On January 1, 2013, the Investor bought 100 shares of XYZ Index ETF for $100 (Block 1). XYZ ETF is now trading for $60, so there is a $4,000 unrealized capital loss. Today, the Investor sells the 100 shares of XYZ ETF at $60, and buys a XYZ index call option with a strike of $60 and a term of one to twelve months. Investor sells the index option post year-end and immediately acquires 100 shares of XYZ Index ETF at the then market price.

Economic Risk: One times the exposure.

Tax Analysis: The sale of the ETF and acquisition of the index option should trigger the wash sale rules and the embedded loss is added to the basis of the option. The option, since it’s a non-equity option, is a Section 1256 contract subject to annual mark-to-market. Thus, the index option will mark at the close of the year and the embedded loss will be recognized and treated as 60% long-term and 40% short-term (which may be helpful or harmful depending on the circumstances).