DEFINITION of Substantially Identical Security
A substantially identical security is one that is so similar to another that the Internal Revenue Service (IRS) does not recognize a difference between the two. Substantially identical securities can include both new and old securities issued by a corporation that has undergone reorganization. Convertible securities and common stock of the same corporation can also fall into this category if the market and conversion prices are similar.
Substantially identical securities cannot be used in tax swaps, or tax loss harvesting strategies, to create capital losses used to offset capital gains made elsewhere. Securities used in such harvesting strategies may be similar but not "substantially identical"; if they are, the IRS will consider the transaction to be a wash sale, and will disallow it including disallowing any of the potential tax benefits.
For instance, if a trader sells Berkshire Hathaway Class A shares at a loss in order to buy Berkshire Hathaway Class B shares, that may be considered a wash sale involving substantially identical securities. However, if the sold the Berkshire Class A shares in order to by shares of a closely related stock, another diversified holding company such as Icahn Industries, that would be fine.
BREAKING DOWN Substantially Identical Security
Tax swaps, or tax loss harvesting strategies, allow an investor to sell a stock or ETF that has gone down in price, incurring a capital loss, in order to offset capital gains earned elsewhere. In order to preserve the overall portfolio strategy, the investor will immediately purchase a very similar security to the one that was sold for a tax loss. For instance, if an investor sells the SPDR S&P 500 ETF (SPY) at a loss, they can immediately turn around and purchase the Vanguard S&P 500 ETF. Tax loss harvesting has become increasingly popular as algorithmic trading and investment management services such as roboadvisors are able to tax loss harvest on your behalf automatically.
The rationale is that the two S&P 500 ETFs have different fund managers, different expense ratios, may replicate the underlying index using a different methodology, and may have different levels of liquidity in the market. Presently, the IRS does not deem this type of transaction as involving substantially identical securities and so it is allowed, although this may be subject to change in the future as the practice becomes more widespread.
However, if the IRS deems the SPDR and Vanguard S&P 500 ETFs to be substantially identical securities, the strategy would not be allowed, and would instead be considered a wash sale. In the United States, wash sale laws are codified in IRS Publication 550, in "26 USC § 1091 - Loss from wash sales of stock or securities," and with corresponding treasury regulations given by CFR 1.1091-1 and 1.1091-2.
Under Section 1091 of the treasury regulations, a wash sale occurs when an investor sells a stock (or other securities) at a loss, and within 30 days before or after the sale:
- Buys substantially identical stock or securities,
- Acquires substantially identical stock or securities in a fully taxable trade,
- Acquires a contract or option to buy substantially identical stock or securities, or
- Acquires substantially identical stock for an individual retirement account (IRA