Swapping One S&P 500 ETF for Another to Harvest a Loss? The Wash-Sale Rule Gets Murky

Year-end is when many investors comb through their accounts looking for losses. One popular move is to sell an S&P 500 ETF that’s trading below what you paid, then immediately buy a near-twin from a different sponsor so you never leave the market. The catch is a 30-day window written into the U.S. Internal Revenue Code, plus a two-word phrase the law never defines.

If you own the SPDR S&P 500 ETF Trust (NYSEARCA:SPY), the Vanguard S&P 500 ETF (NYSEARCA:VOO), or the iShares Core S&P 500 ETF (NYSEARCA:IVV), this affects you directly. Does switching one for another keep the loss, or does the IRS take it back?

How the Wash-Sale Rule Catches Year-End Swaps

Tax-loss harvesting means selling an investment at a loss so the loss can offset capital gains on your tax return. The wash-sale rule is there to stop people from gaming it. Under 26 U.S.C. § 1091(a), no loss deduction is allowed if, within a period beginning 30 days before the sale and ending 30 days after it, you acquire substantially identical stock or securities.

The window runs in both directions. A purchase made weeks before the sale counts just as much as one made the next morning. The statute also covers entering into a contract or option to acquire those securities, so buying call options on the same fund can trigger the rule.

IRS Publication 550 adds that buying substantially identical stock for your IRA or Roth IRA counts too. So does a purchase by your spouse.

Same Index, Three Sponsors and a Phrase Nobody Defined

Section 1091(a) never defines “substantially identical” in its text. That gap is why same-index trades are unclear.

All three funds track the S&P 500. According to iShares’ statement of additional information for IVV, that’s a capitalization-weighted index of approximately 503 large U.S. companies. The funds come from three different sponsors: Vanguard, BlackRock’s iShares, and State Street.

What a Disallowed Loss Costs You

Two terms come into play here. Your cost basis is what you paid for your shares, and it’s the figure used to work out your gain or loss when you sell. Your holding period is how long you’ve owned the shares, which determines whether a gain is taxed as short-term or long-term.

If the wash-sale rule applies, IRS Publication 550 says you add the disallowed loss to the cost of the new stock or securities, which defers the deduction until you sell those shares. The new shares’ holding period also includes the time you held the shares you sold. The statute sets out both adjustments in Section 1091(d) and Section 1223(3).

That means the loss stays on your books, but it can’t offset this year’s gains, and offsetting this year’s gains was the whole reason to harvest it.

Your Own Dividend Reinvestment Can Trip the Rule

Publication 550 notes that most funds let shareholders automatically reinvest distributions in more shares. A reinvestment is a purchase. If you sell part of a position at a loss and the same fund reinvests a dividend inside the window, those new shares can be matched against the shares you sold.

The publication’s own examples show a loss being split this way, with only the matched portion disallowed. 24/7 Wall St. covered the same trap with a monthly payer in Selling JEPI at a Loss While Reinvesting Its Monthly Check Hands Part of the Tax Loss Back to the IRS.

How to Shrink the Gray Area Before December 31

Investors who want less uncertainty usually go one of two ways. One is buying a replacement fund that tracks a different index, which puts more distance between the two holdings. The other is waiting until the window after the sale has closed before buying back in. Both cut down the gray area, though the IRS offers no formal safe harbor (a guaranteed-safe method) for either.

Before you place a year-end trade, run through this checklist:

• Review every purchase of the fund in the window before your planned sale, across taxable accounts, IRAs, and your spouse’s accounts.
• Turn off automatic dividend reinvestment on the fund you plan to sell.
• Avoid buying options or contracts on the fund during the window.
• Determine whether your replacement changes the index or only the sponsor.

Switching between same-index ETFs is a judgment call the tax code doesn’t settle. Investors who want certainty on a year-end loss should change the index, not just the sponsor, or wait out the full window before buying back.

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