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.
