In today’s investing landscape, it is common for brokers or advisory firms to use multiple third-party managers to invest portions of their clients’ money. It is also common to receive investment management services from multiple firms or advisors at different firms. However, this can create unintended adverse tax consequences for investors.
There are many reasons why a person or entity would want multiple accounts, and possibly multiple advisors, managing their investments or parts of their investments. These are often rooted in not wanting all of one’s money with one person or firm in order to protect assets, gain multiple perspectives and harness intellect and experience. While this may give people perceived diversification, these types of arrangements can cause very specific and ultimately harmful conflicts of interest for investors, if not managed and watched carefully. (For related reading, see: Top Four Signs of Over Diversification.)
Adverse Tax Consequences
The wash sale rule disallows losses for tax purposes. It occurs when a tax payer sells stock or securities at a loss and reinvests in substantially identical stock or securities within 30 days, before or after the date of sale. There is a 61-day window where this rule can apply which many confuse with a 30-day window of time.
Wash Sale Rule: An Example
An Investor owns stock XYZ at a loss and would like to recognize that loss to offset capital gains and generate up to a $3,000 deduction versus ordinary income and/or have a carry forward of anything more than the $3,000 loss to offset gains in future years. They sell the stock in their portfolio at a loss. If they were to buy this stock again within 30 days of this sale, the loss would not be allowed and an adjustment (increase) in their new cost basis for the previous taken loss would occur. This reduces the potential gain on a future sale of the stock, effectively deferring the benefits of the loss from the original sale.
It is important to remember that this rule applies to a window of time, 61 days of taking the loss. A common strategy is to double up on a stock position with the advanced knowledge that the investor will sell the lot or shares that have a loss and hold the others to maintain exposure in the investment. This occurs because there is a notion it will be a good longer-term investment. It is important to understand that a purchase prior to the loss sale could have a similar effect. Various transactions qualify as re-acquisition during this time frame. They include the purchase of the same stock whether in the same account or not, purchase of an option, being granted a stock option, exercising a stock option or reinvesting a dividend that automatically purchases more shares of the stock. (For more, see: Can IRA Transactions Trigger the Wash-Sale Rule?)
It is easy to see that buying and selling to oneself can occur, if not watched out for. This could happen especially in the case where one manager likes a stock because it is now considered a value stock and fits their mandate, while another is selling it from their portfolio of growth stocks, because it no longer meets their portfolio management mandate. If the investor's accounts are held at the same investment firm when there is more than one account held with different managers, this could easily occur.
Another common scenario is that the investor has multiple firms they work with independent of each other. One account at one firm is buying a stock that the other is selling at a loss to generate the tax benefits of taking a loss.
Having all your money at one firm who can offer diversification and access to top quality products, managers and investment professionals with an eye on managing these portfolio conflict of interest issues, is key to successfully limiting conflicts and adverse tax scenarios. (For related reading, see: In Praise of Portfolio Simplicity.)