Here's How to Sell Losing Stocks, Offset Gains, and Work Around the 'Wash Sale' Rule

With the year quickly winding down, there’s less than two weeks left to engage in tax-loss harvesting, a strategy to offset taxable gains by selling underperforming stocks. While the concept may sound straightforward, executing it effectively requires careful planning and understanding of IRS rules.

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The easier part of tax-loss harvesting is identifying and selling a losing stock by December 31. If the stock is held in a taxable account, the loss can be used to offset capital gains for 2024, reducing your tax burden. However, complications arise if you believe the stock remains a solid investment despite its current loss. The challenge lies in the IRS’s “wash-sale rule,” which prohibits you from repurchasing the same or a “substantially identical” security within 30 days of the sale if you want to claim the loss for tax purposes. This rule means you’ll be unable to benefit from any potential rebound in the stock’s value during that 30-day period.

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This 30-day exclusion isn’t just a theoretical inconvenience. Historically, stocks that experience significant losses within a year often bounce back once tax-loss selling subsides. As a result, there’s a real risk of missing out on potential gains while staying out of the position.

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To mitigate this risk, you can employ a workaround: substitute the sold stock with a similar, but not identical, one. By holding the substitute stock for the required 30 days before returning to your original holding, you can maintain comparable market exposure while still utilizing the tax loss. The key, however, is ensuring that the substitute stock isn’t considered “substantially identical” by the IRS, as this would invalidate the tax-loss claim.

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This distinction is particularly important when dealing with exchange-traded funds (ETFs). For example, selling shares in the SPDR S&P 500 ETF (SPY) and replacing them with the Vanguard S&P 500 ETF (VOO) wouldn’t comply with the wash-sale rule because the two ETFs are nearly identical. Unfortunately, the IRS hasn’t provided clear guidelines on what qualifies as “substantially identical,” making it essential to consult a financial advisor or tax attorney to ensure compliance.

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When dealing with individual stocks, navigating the wash-sale rule is typically more straightforward, provided you avoid substituting different share classes of the same stock. For instance, swapping Berkshire Hathaway Class A shares (BRK.A) for Class B shares (BRK.B) would not qualify for tax-loss harvesting.

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Outside such specific cases, finding a comparable substitute stock is usually manageable. Start by reviewing a year-to-date performance ranking of stocks. Many financial websites provide up-to-date lists of stocks sorted by their annual performance. Look for a stock in the same industry with a loss of a similar magnitude to the one you’re selling. Chances are, both stocks will exhibit similar performance trends over the 30-day period.

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For example, consider Halliburton Co. (HAL), an oil services company that recently ranked 470th among S&P 500 stocks for year-to-date performance. Schlumberger (SLB), another oil services company ranked 471st, showed nearly identical returns during the same period. Selling Halliburton shares and replacing them with Schlumberger for 30 days could allow you to harvest the tax loss with minimal impact on your portfolio’s performance.

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If a suitable substitute stock isn’t available, consider using an ETF that tracks the same industry or sector. Tools like the “Correlation Tracker” on the Select Sector SPDRs website can help. By entering the ticker symbol of the stock you sold, the tracker identifies which Sector SPDR ETF has the highest correlation coefficient. The higher the correlation, the more confidence you can have in using the ETF as a temporary substitute.

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Even if you can’t find a perfect replacement, the benefits of tax-loss harvesting often outweigh the drawbacks. For example, if you’re in the 20% tax bracket, selling a losing position could reduce your tax liability by up to 20% of the loss amount. This reduction represents a tangible financial advantage that can enhance your overall portfolio management strategy.

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In conclusion, while tax-loss harvesting can effectively minimize your tax bill, it requires careful consideration of IRS rules and strategic planning to avoid missing out on potential market gains. Whether you choose to substitute with another stock or an ETF, consulting a financial professional can help ensure compliance and optimize your tax savings.

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