Week 42 Day 2: The Wash Sale Rule: The IRS Trap You Must Avoid

You sell VTI at a loss on December 1st. You buy VTI again on December 15th. The IRS says: 'Nice try. That loss is disallowed.' You wasted the harvest. Instead: sell VTI on December 1st, buy ITOT (similar but not identical) on December 1st. Wait until January 2nd (31 days later), then sell ITOT and buy VTI back if you prefer. The loss is preserved.

Wash sale details and traps: (1) The 61-day window. The wash sale period is 30 days BEFORE and 30 days AFTER the sale = 61 total days. If you bought more VTI on November 5th (less than 30 days before your December 1st sale), the loss may be partially disallowed. (2) Across all accounts. If you sell VTI at a loss in your taxable account and your spouse buys VTI in their IRA within 30 days, the wash sale rule may apply. The rule covers your accounts, your spouse's accounts, and accounts you control (trusts, business accounts). (3) DRIP trap. If VTI's DRIP (dividend reinvestment plan) automatically buys shares within the 30-day window, it triggers a wash sale. Turn off DRIP before harvesting, or harvest at least 31 days after the last dividend payment. (4) 'Substantially identical' is not precisely defined. The IRS provides limited guidance. General consensus: (a) VTI -> ITOT is likely NOT substantially identical (different fund families, different indices). (b) VTI -> VTI is definitely substantially identical. (c) Selling a stock and buying a call option on the same stock IS substantially identical. (d) VTI -> VTSAX (same fund, different share class) is likely substantially identical. Safe harvesting pairs: VTI -> ITOT or SCHB. VXUS -> IXUS or SPDW. BND -> AGG or SCHZ. SCHD -> VYM or SPYD. VCIT -> LQD or IGIB. These pairs track different indices with high correlation, maintaining your market exposure while avoiding wash sale issues.

The wash sale rule (IRC Section 1091) was enacted to prevent taxpayers from claiming artificial losses by selling and immediately repurchasing the same security. The statute disallows losses on sales of 'stock or securities' if the taxpayer acquires 'substantially identical' stock or securities within 30 days before or after the sale. The disallowed loss is added to the cost basis of the replacement security, deferring (not eliminating) the tax benefit. 'Substantially identical' is not defined in the statute or regulations. Revenue Ruling 2008-5 confirmed that the rule applies across all accounts of the same taxpayer (including IRAs -- a wash sale in an IRA permanently destroys the loss, as opposed to deferring it). The intersection of the wash sale rule with ETF investing is an area of regulatory ambiguity: the IRS has not ruled on whether two ETFs tracking different versions of broad market indices (e.g., VTI tracking CRSP US Total Market vs. ITOT tracking S&P Total Market) are substantially identical. Tax practitioners generally opine that different indices constitute different securities (because the underlying holdings, weighting methodology, and reconstitution schedules differ), but no definitive guidance exists. The direct indexing approach (holding individual stocks instead of ETFs) eliminates this ambiguity entirely: selling Apple and buying Microsoft is clearly not a wash sale, and the individual-stock approach generates 3-5x more harvesting opportunities per year because individual stocks have higher idiosyncratic volatility than diversified ETFs.