What Is a Substantially Identical Security?
The term "substantially identical security" comes from the language and explanation published by the U.S. Internal Revenue Service (IRS) regarding the rules of a wash sale. Securities that meet this definition are not recognized as different enough to be considered separate investments. Substantially identical securities can include both new and old securities issued by a corporation that has undergone reorganization or convertible securities and common stock of the same corporation. Securities usually fall into this category if the market and conversion prices are the same and are therefore not allowed to be counted in tax swaps or other tax-loss harvesting strategies.
Key Takeaways
- Substantially identical security is a phrase that comes from the tax explanation of the wash-sale rule.
- Traders cannot expect to use tax-loss harvesting strategies if they have sold and then reacquired substantially identical securities within 30 days.
- Generally, this can be avoided by purchasing similar stock or securities issued by a different corporation.
Understanding a Substantially Identical Security
Tax swaps, or tax-loss harvesting strategies, allow an investor to sell a stock or exchange-traded fund (ETF) that has gone down in price and thus incur a capital loss. This helps investors reduce taxes from capital gains earned elsewhere. Tax-loss harvesting has become increasingly popular as algorithmic trading and investment management services such as robo-advisors are able to tax-loss harvest on your behalf automatically.
However, to preserve their overall portfolio strategy, some investors will immediately purchase a very similar security to the one that was sold for a tax loss, hoping that it will return to, and perhaps exceed, its former value. For example, if an investor sells the (SPY) at a loss, they may immediately turn around and purchase the Vanguard S&P 500 ETF (VOO).
The rationale is that the two S&P 500 ETFs have different fund managers and different expense ratios, may replicate the underlying index using a different methodology, and may have different levels of liquidity in the market. Presently, the IRS does not deem this type of transaction as involving substantially identical securities, and so it is allowed, although this may be subject to change in the future as the practice becomes more widespread.
In another example, if a trader sells Berkshire Hathaway Class A shares at a loss in order to buy Berkshire Hathaway Class B shares, that may be considered a wash sale involving substantially identical securities because the two securities market the same portfolio at different price points. However, if they sold the Berkshire Class A shares in order to buy shares of a closely related stock issued by another company, the wash sale rules would not apply.
Wash Sales
If the IRS deems Berkshire Class A and Berkshire Class B shares to be substantially identical securities, the tax benefits gained from the strategy would not be allowed by the IRS, and would instead be considered a wash sale. In the United States, wash sale laws are codified in the Internal Revenue Code and Treasury regulations. Capital gains and losses, including those related to wash sales, are reported using IRS Schedule D (Form 1040).
Under Section 1091 of the Treasury regulations, a wash sale occurs when an investor sells stock (or other securities) at a loss, and within 30 days before or after the sale:
- Buys substantially identical stock or securities
- Acquires substantially identical stock or securities in a fully taxable trade
- Enters into a contract or option to buy substantially identical stock or securities
- Acquires substantially identical stock for an individual retirement account (IRA) or Roth IRA
What Is the Substantially Identical Security Rule?
The substantially identical security rule is designed to prevent investors from selling stock or securities to claim a loss on their taxes and then buying back the same—or basically the same—security within 30 days before or after the sale.
What Is an Example of the Wash Rule?
An example of the wash sale rule would be if an investor holds shares of XYZ Corp. and sells them for a capital loss, but wishes to repurchase shares as part of their investment strategy. Under the wash rule, that investor would need to wait more than 30 days past the sale if they want to be able to repurchase shares of XYZ Corp. and have the IRS allow them to claim the capital loss on their taxes.
What Is Considered a Substantially Identical Security?
The IRS does not spell out exactly what makes one security substantially identical to another, but rather states you must consider all relevant "facts and circ*mstances" of the case. Generally, stocks of two different companies would not be substantially identical, except in the event of a reorganization. Neither would be the stocks and bonds issued by the same company, unless those securities are convertible.
The Bottom Line
The IRS enforces its wash sale rules, so it's important to understand the impact of buying and selling substantially identical securities within a short time frame. If you want to maximize your tax-loss harvesting strategies, pay close attention to the sale date and subsequent purchase date of any securities that could be substantially similar to each other. These rules apply to purchases within 30 days before or after a sale.
FAQs
Q: How does the wash sale rule work? If you sell a security at a loss and buy the same or a substantially identical security within 30 calendar days before or after the sale, you won't be able to take a loss for that security on your current-year tax return.
Does RSU vesting trigger wash sale? ›
Regarding your second question, if the ISO purchase and sale occurred four days after the RSU vesting, and the ISO sale resulted in a loss, then the RSU vesting would also trigger the wash sale rule. In this scenario, the ISO loss would be disallowed.
What is the IRS rule on wash sales? ›
The IRS instituted the wash sale rule to prevent taxpayers from using the practice to reduce their tax liability. Investors who sell a security at a loss cannot claim it if they have purchased the same or a similar security within 30 days (before or after) the sale.
How do you count days to avoid a wash sale? ›
Keep in mind that the wash sale rule goes into effect 30 days before and after the sale, so you have a 61-day window to avoid buying the same stock.
Can you sell and then rebuy the same stock? ›
You can buy the same stock back at any time, and this has no bearing on the sale you have made for profit. Rules only dictate that you pay taxes on any profit you make from assets. To profit in stocks, means that you make rich rewards.
How to avoid RSU wash sale? ›
To avoid triggering the wash sale rule, an investor can employ a strategy such as buying more of the stock that they'd like to sell, holding on to the new stock purchase for 31 days, and then selling it. An investor could also sell a stock at a loss, register the loss, and then buy a similar investment.
How to avoid wash sale with RSU vesting? ›
To avoid a wash sale, you should wait at least 31 days before repurchasing similar securities after selling RSUs at a loss. Additionally, it's important to note that the wash sale rule applies to each individual account you own, so you can't offset a loss in one account with a gain in another account.
Are wash sale losses gone forever? ›
Don't fret that you'll lose your tax break forever due to the wash-sale rule, however. The ability to claim your loss is only deferred, not eliminated. Simply do not re-buy the asset in the 30-day window, and you can safely claim the loss on your tax return and without any further penalty.
What triggers a wash sale rule? ›
More specifically, the wash-sale rule states that the tax loss will be disallowed if you buy the same security, a contract or option to buy the security, or a "substantially identical" security, within 30 days before or after the date you sold the loss-generating investment (it's a 61-day window).
What happens if you break the wash sale rule? ›
“Violating the wash-sale rule disallows you the tax benefit you receive from taking a tax loss,” said Westin McEntire, senior portfolio manager at Venturi Wealth Management in Austin, Texas. You don't miss out entirely, but it's included in the cost basis of the new investment you buy.
Q: How does the wash sale rule work? If you sell a security at a loss and buy the same or a substantially identical security within 30 calendar days before or after the sale, you won't be able to take a loss for that security on your current-year tax return.
What is substantially identical? ›
The tax regulations say that if two different stocks are linked together in such a way that any change in the price of one will be reflected in the price of another, they're likely to be treated as substantially identical securities for purposes of the wash sale rule.
Why are capital losses limited to $3,000? ›
The $3,000 loss limit is the amount that can be offset against ordinary income. Above $3,000 is where things can get complicated.
What is substantially identical wash sale? ›
In the case of substantially identical, the most relevant guidance appears in Publication 550, which states, “In determining whether stock or securities are substantially identical, you must consider all the facts and circ*mstances in your particular case.” The Publication clarifies that “ordinarily, stocks or ...
What is the penalty for a wash sale? ›
If you trigger a wash sale, the amount of loss that is not deductible will be added to the cost of the newly purchased, substantially identical stock. This means that if you later sell the newly purchased stock at a gain, you will pay less in taxes.
How do you count 30 days for a wash sale? ›
A Wash Sale occurs if you sell securities at a loss and buy substantially identical replacement shares within 30 days before or after the sale. The Wash Sale Period is 30 days before and 30 days after the sale date, totaling 61 days (including the sale date).
Should I sell RSUs immediately after vesting? ›
Selling RSUs immediately upon vesting is a common approach for many individuals. The reason behind this strategy is to avoid any potential decline in the company's stock value. By selling right away, you can lock in the value of your shares and mitigate potential risks tied to stock market fluctuations.
What happens when you sell vested RSU? ›
short-term capital gains tax rates: If you sell your RSUs immediately upon vesting, any gain will be subject to short-term capital gains tax rates, which are generally higher than long-term capital gains tax rates 6.
What happens to unvested RSUs when a company is sold? ›
Depending on if the acquired company is public or private, exercised and vested holdings (shares, options, and restricted stock units (RSUs)) may be converted to stock in the new company. Unvested holdings may be converted to unvested holdings in the new company, but they might be subject to a revised vesting schedule.
Why did my RSU automatically sell? ›
Most employers handle tax withholding for RSUs on your behalf by applying the 'sell to cover' strategy. This involves selling a portion of your RSUs as they vest to cover the tax liability. The remaining shares are then distributed to you.
