Substantially Identical Security: Definition and Wash Sale Rules

What Is a Substantially Identical Security?

The term "substantially identical security" comes from the language and explanation published by the U.S. Internal Revenue Service (IRS) regarding the rules of a wash sale. Securities that meet this definition are not recognized as different enough to be considered separate investments. Substantially identical securities can include both new and old securities issued by a corporation that has undergone reorganization, or convertible securities and common stock of the same corporation. Securities usually fall into this category if the market and conversion prices are the same and are therefore not allowed to be counted in tax swap or other tax-loss harvesting strategies.

Understanding a Substantially Identical Security

Tax swaps, or tax-loss harvesting strategies, allow an investor to sell a stock or exchange-traded fund (ETF) that has gone down in price and thus incur a capital loss. This helps investors reduce taxes from capital gains earned elsewhere. However, to preserve their overall portfolio strategy, some investors will immediately purchase a very similar security to the one that was sold for a tax loss, hoping that it will return to, and perhaps exceed, its former value.

For example, 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 robo-advisors 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.

In another example, 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 because the two securities market the same portfolio at different price points. However, if they sold the Berkshire Class A shares in order to buy shares of a closely related stock issued by another company, the wash sale rules would not apply.

Wash Sales

If the IRS deems Berkshire Class A and Berkshire Class B shares to be substantially identical securities, the tax benefits gained from the strategy would not be allowed by the IRS , and would instead be considered a wash sale. In the United States, wash sale laws are codified in the Internal Revenue code and Treasury regulations. Capital gains and losses, including those related to wash sales, are reported using IRS Schedule D (Form 1040).

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,
•    Enters into a contract or option to buy substantially identical stock or securities, or
•    Acquires substantially identical stock for an individual retirement account (IRA) or Roth IRA.