Tax costs for poorly timed stock transactions

Investors who deal in individual stocks usually don't have problems. It's easy to tell what stocks the IRS might deem substantially similar. Just how does the same asset rule work for investors who trade mutual funds?

Let's look at Joe's portfolio again. This time he's closing out his Fidelity XYZ Growth Fund account at a loss. He believes, however, that the sector is poised for growth, so he uses his XYZ proceeds to immediately buy shares of Pioneer XYZ Growth Fund. Since both funds are invested in telecom holdings, has Joe violated the wash sale rule?

No, says Van Grevenhof. As far as the IRS is concerned, the Fidelity and Pioneer funds are not essentially the same investment.

But be careful with exchange-traded funds, or ETFs. "I sell my IBM stock and book a loss," says Van Grevenhof. "I can't buy IBM for 30 days and there is no other similar stock I want to buy, so I buy an ETF in a computer industry fund. That's not a problem. But say that industry ETF buys computer-type stocks and 2 percent of the fund is IBM. Theoretically, the IRS could come back and say 98 percent is OK, but you owe tax on the 2 percent."

So far though, says Van Grevenhof, that's never happened. But the possibility it could is good to know, just in case the agency ever decides to make it an issue.

And the IRS always has the power to disregard what it considers a sham transaction. Even if you made it look like a substantially different security, if the IRS identifies that there is no economic substance to the transaction, it will disallow the loss.

IRA swap eliminated

Some investors had tried to work around the wash sale rule by buying the sold or similar stock for an individual retirement account, or IRA. In these cases, they argued, because the retirement plan -- Roth or traditional -- is separate from the taxpayer's individual personal holdings, the wash sale rules shouldn't apply.

The IRS, however, has officially nixed such transactions as a way to circumvent the wash sale rules.

In Revenue Rule 2008-5, published Jan. 22, 2008, the IRS says "if an individual sells stock or securities for a loss and causes his or her IRA or Roth IRA to purchase substantially identical stock or securities within a specified period, the loss on the sale of the stock or securities is disallowed under section 1091, and the individual's basis in the IRA or Roth IRA is not increased by virtue of section 1091(d)."

Essentially, that means the IRS recognizes that the individual investor and the IRA investor are one person, so the wash sale rules apply.


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