Let us suppose that you bought 1,000 shares of Barrick Gold (ABX) two years ago at $50. With the stock down to $18, you're looking at a $32,000 paper loss. You could sell the stock, capturing a capital loss deduction. But you don't want to sell out at what may be a bottom. You are sure that shares of the gold miner will recover as soon as soft-money advocate Janet Yellen takes over at the Federal Reserve.
Sell for the loss and then buy right back? That doesn't work. Congress thought of that trick and, close to a century ago, defined a "wash sale" as the repurchase within 30 days of what was sold at a loss. Someone with a wash sale cannot deduct the loss immediately; instead, the loss gets added to the cost basis of the new position. It's as if the two trades didn't happen.
Well, why not sell Barrick shares and replace them with something slightly different–like a call option that would give you most of the upside? That doesn't work, either. The tax writers thought of that one and decreed that the wash sale rule applies if you buy any call option in Barrick, no matter the strike price or expiration date. Gotcha!
But wait. With two antitrader rules in place, investors can turn the tables on the IRS. Robert Gordon, whose Twenty-First Securities Corp. specializes in complicated trades, explains how: You sell the losing stock and immediately buy an option on it. For example, you sell your 1,000 Barrick shares and buy 10 calls (each representing 100 shares) with a strike price of $20 and an expiration in December. Those calls were recently trading at 29 cents, or $290 for options on 1,000 shares.
You have thereby triggered the wash sale rule–deliberately. The statute forces you to incorporate your loss on the stock into the price of the calls. You now have almost worthless calls with a cost basis of $32,290.next day you buy 1,000 Barrick shares.
The calls probably expire worthless and you have a $32,290 capital loss to claim. Or maybe Barrick rebounds to $21 and your loss is $31,290. The key fact, Gordon explains, is that selling an option at a loss and then buying the stock does not constitute a second wash sale. That's because the statute's linking of stocks and options works in one direction only.
Should this loophole be closed? Probably. In 2004 David Schizer, dean of Columbia's law school, published a paper pleading with tax writers to overhaul the wash sale rule. They haven't, and they are unlikely to undertake any reforms soon, given the congressional impasse over bigger issues (like whether to raise taxes or cut entitlements).
Meanwhile, Gordon finds even more room for mischief from legislators' clumsy drafting. Suppose you bought the gold miner two years ago and are throwing in the towel. Your $32,000 loss is going to be a long-term capital loss if you sell the stock and buy the call; the wash sale rule punishes sellers by carrying over the old holding period to the new position.
This is a punishment because short-term capital losses are more desirable than long-term ones. Depending on your circumstances, they may be worth twice as much.
To evade the punishment, Gordon suggests, do this: Sell the Barrick shares, buy an in-the-money call that is about to expire, exercise the call, then sell the newly acquired shares at a loss. You wind up with a short-term capital loss.
How did that happen? Congress, evidently wanting to make favorable long-term treatment hard to get for winning trades, decided that exercising a call resets your holding period to zero.
Here's another way to duck the wash sale problem—imperfect in maintaining your position but easier to implement. Temporarily (that is, for 31 days) swap out of one mining stock like Barrick into a collection of mining stocks like the Market Vectors Gold Miners ETF (GDX). After the required wait, switch back. You could work this trick in reverse, too, taking a loss on GDX, using Barrick to maintain a bullish stake on the metal for a month, then swapping back.
Now let's suppose you have taken a shellacking on bullion, not on a mining company. You own the metal via SPDR Gold Shares (GLD), for example. Sell the fund, immediately buy a long-shot call option on it, then the next day buy more of the fund. (In principle, this strategy works with other bullion ETFS, like SGOL and IAU, but their options aren't very liquid.)
The evasion of the wash sale rule proceeds much as it does with mining-company shares. But in this case a long-term loss is partly converted into a more valuable short-term one. Why is that? The tax writers were trying to crack down on commodity traders who'd close out losing positions in December and winners in January, postponing tax bills indefinitely.
To stop that wickedness Congress ordered that commodity options be "marked to market." A compromise had the gains and losses treated as if they were 60% long, 40% short, no matter their true history. The reform ended up creating this lovely opportunity.
This is how the tax code gets messier over time. It's like a paint can lid. When legislators whack down on one side it pops up on the other.
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