How ETFs circumvent IRS wash-sale rules

Institutional investors are harvesting ETF losses for tax purposes, then placing their assets in highly correlated funds — regardless of so-called wash-sale restrictions, a new study found.

In theory, IRS guidelines prohibit investors from buying “substantially identical” securities 30 days before or after selling them. 

In practice, fund managers, pensions, insurance firms, endowments and other institutional investors “engage in substantial swapping” of ETFs with holdings that are 99% or more the same thing to the tune of $417 billion in assets since 2001 and $106 billion in 2022 in transactions that “seem to lack economic substance beyond harvesting capital losses,” according to a working academic paper released this summer and revised last month by four professors of business and management. The findings, which echo those of another working paper from earlier this year, shed more light on how ETFs help financial advisors and their clients offset the taxes on capital gains by booking losses in their portfolios.

“While the economic intent of the wash sale rule is straightforward, significant uncertainty remains as to the permissibility of tax deductions achieved through ETF swaps,” the report’s authors — Michael Dambra of the University of Buffalo and Andrew Glover, Charles M.C. Lee and Phillip Quinn of the University of Washington — wrote in the introduction. “Specifically, the IRS has not ruled on what constitutes a ‘substantially identical’ security, leaving financial advisors to navigate a foggy legal landscape. Some advisors seem to take the regulatory silence as tacit permission to swap ETFs that hold identical securities or that are even benchmarked to the same index (e.g., Lasser 2011). Others argue that if an investor’s economic position has not changed after swapping ETFs, the spirit of the wash sale rule has likely been violated (e.g., Fischer 2010). Against this backdrop of legal uncertainty, the extent to which investors engage in tax avoidance through ETF wash sales remains largely unknown.”

READ MORE: How a newly unified GOP government will affect ETFs

Representatives for the SEC declined to comment on the report’s conclusions and referred questions to the IRS, which didn’t provide a response.

The findings essentially “confirmed what all of us expected,” but “what was striking about the study was being able to demonstrate that the loss harvesting was material enough to be measured,” said Steve Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center, a nonpartisan think tank.

Tax strategies around possible wash sales have been “going on for decades and decades and decades,” he noted. The rise of ETFs — which topped $10 trillion in assets for the first time in September in a shift fueled by technology, lower fees and tax advantages — has altered the picture. But it’s not clear whether IRS policymakers or members of Congress will try to rein in the wash-sale practices documented in the report.

“I don’t think they view this as high on their agenda, because there’s other tax evasion that goes on. This is lawful, and the question is whether it’s pushing the limits,” Rosenthal said in an interview. “It’s just easier now. There are more vehicles, there are more opportunities, there is more technology to help plan and there are more people marketing these strategies as a result of the ease.”

The study hasn’t been published by a peer-reviewed journal, and the researchers listed some possible “sources of noise” in the data they tracked from quarterly SEC filings of firms’ holdings known as Form 13F and granular trading records from financial technology firm AbelNoser Solutions, a Trading Technologies company. Some swap trades of correlated ETFs could have occurred at random, between the quarterly filings, at lower than 99% matches in their holdings or at an even greater volume when considering the growth of ETFs, the authors wrote.

“Exchange-traded funds provide an efficient way for investors to circumvent the trading frictions associated with the wash sale rule,” Dambra and the other academics wrote. “Specifically, investors can sell a depreciated ETF security and realize a capital loss while simultaneously purchasing another ‘nearly identical’ ETF security. This form of swap trading allows investors to maintain a substantively identical economic position while harvesting a capital loss that can be used to offset realized gains and other taxable income. With an explosion in available ETFs over the past two decades, these securities have become ideal vehicles for circumventing the wash sale rule.”

READ MORE: The most wonderful time of the year, for tax-loss harvesting

Their research suggests that ETFs can offer even greater tax efficiency than many experts have pointed out in the past — or that the IRS may be ignoring the enforcement of a rule that has restricted loss harvesting maneuvers for more than a century.   

“The expansion of ETFs has provided investors with a new, low-cost tool whereby capital losses can be realized without disturbing an optimal portfolio,” the authors wrote. “Similar to the findings in Li (2024), we find the introduction of a near-identical ETF leads to more volume activity for the incumbent ETF. Next, we find that tax-sensitive institutions hold a more diverse set of highly correlated ETFs, invest a larger portion of their AUM in these ETFs, engage in more swapping between near-identical ETFs and capture more capital losses with this swapping activity. We estimate conservatively that capital loss recognition attributable to annual swapping among tax-sensitive institutional investors is in the tens of billions of dollars. While this behavior is becoming increasingly widespread and economically important, regulators have remained silent on where ETFs fit in their definition of ‘substantially identical securities.’ We contribute to the policy discussion on the potential costs of that continued silence.”