(MONEY Magazine) – WASH-SALE WRINKLES? Last June we advised fund investors to consider taking losses on their losers and replacing them with similar investments ("Got Lemons? Make Lemonade"). For example, Janus Mercury owners could cut their losses and buy the similarly aggressive White Oak Growth Stock instead. This would allow them to 1) use losses to offset other gains or income on their tax return, 2) maintain exposure to the same area of the market, and 3) avoid running afoul of the wash-sale rule, which prevents investors from claiming a loss if they buy a "substantially identical" security within 30 days.
We also noted that investors might swap two index funds--take losses in, say, Vanguard Total Stock Market Index and buy Fidelity Spartan Total Market Index instead. Some readers have taken us to task, using a commonsense interpretation of "substantially identical." But while the Internal Revenue Service has no stated policy on mutual fund swaps, other remarkably similar securities have not met its definition of "substantially identical" if they are issued by different companies. That said, this is a gray area, and the IRS could someday rule against the practice. As Vanguard tax expert Joel Dickson says, "Get two accountants and you could hear four stories." That's why Vanguard and Fidelity are reminding investors who sell funds and buy similar offerings that the IRS guidelines are fuzzy; it's up to you and your tax adviser to decide how to interpret them.
To play it safer, consider swapping funds that track different indexes. The IRS doesn't specifically discuss this maneuver either, but Dickson believes that one could take losses on Vanguard 500 Index and buy Vanguard Total Stock Market. Rick Ferri, a money manager in Troy, Mich., suggests swapping Vanguard Total Stock Market, which tracks the Wilshire 5000, with TIAA-CREF Equity Index, which follows the Russell 3000.
But every conclusion is theoretical until the IRS says otherwise. There's the letter of the law and then there's the spirit. After all, the long-term performance numbers of many large-cap indexes are in fact "substantially identical."