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Tax Rules for Losses on ETFs

  • J.K. Lasser logo J.K. Lasser
  • Taxes
  • Exchange-Traded Funds
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Exchange-traded funds (ETFs) have some features of both individual stocks and mutual funds, but are unique investment vehicles. Investors buy shares in ETFs just like they would buy stock in corporations. They hope to make a profit from these purchases, but things don’t always work out. What happens if you suffer a loss when you sell your ETF shares?

Tax loss rules

Losses in ETFs usually are treated just like losses on stock sales, which generate capital losses. The losses are either short term or long term, depending on how long you owned the shares.

  • If you held them for one year or less, the loss is short term
  • If more than one year, the loss is long term.

These capital losses can be used to offset capital gains (from any investments, not just ETFs) and up to $3,000 of ordinary income ($1,500 for married persons filing separately). Capital losses in excess of these limits can be carried forward and used in future years. There is no limit on the years that the excess losses can be carried forward.

Harvesting losses

One of the opportunities that holding ETF shares presents is the ability to cherry-pick shares to be sold for optimum tax results. For example, say an investor buys 100 shares of XYZ ETF in January 2011 for $100 a share and another 100 shares in February 2013 for $150 a share. When the price of the shares drops to $90, the investor opts to sell half of the holdings. By designating that the February 2013 lot should be sold, the investor has maximized the loss ([$150 - $90] x 100 shares).

For tax purposes, in order that the correct basis for the lot be used in determining the loss, the investor must identify to the broker the shares that will be sold and receive written confirmation of the specification within a reasonable time. In the absence of such identification, it is assumed for tax purposes that the first shares acquired are the first shares sold. In the example above, this would mean that the January 2011 shares with a basis of $100 each would have been sold, minimizing the tax loss that the investor can recognize.

Watch the wash sale rule

If you buy substantially identical security within 30 days before or after a sale at a loss, you are subject to the wash sale rule. This prevents you from claiming the loss at this time. The wash sale rule also applies to acquiring a substantially identical security in a taxable exchange or acquiring a contract or option to buy a substantially equal security.

The tax law does not define substantially identical security, but it’s clear that buying and selling the same security meets the definition. For example, if you sell shares in the XYZ ETF at a loss and buy it back within the wash sale period, you cannot take the loss now. There has been no IRS ruling on whether ETFs from two different companies that track the same index are considered substantially identical.

ETFs can be used to avoid the wash sale rule while maintaining a similar investment holding. This is because ETFs typically are an index for a sector or other group of stocks and are not substantially identical to a single stock. For example, if you sell the stock of a drug company, such as Pfizer, Merck, or Johnson & Johnson, at a loss and then buy an ETF that tracks the drug companies, the wash sale rule does not apply. Examples of ETFs in this sector include iShares Dow Jones U.S. Pharmaceuticals, PowerShares Dynamic Pharmaceuticals, and SPDR S&P Pharmaceuticals.

It could also be argued that a sale of mutual fund shares at a loss, followed by the purchase of an ETF that is similar to the mutual fund, is outside the wash sale ban. The ETF price usually reflects the prices of the stocks it holds, whereas mutual funds shares tracking similar holdings may not have the same underlying value. In addition, there are different fees or other charges associated with mutual funds versus ETFs.

You cannot skirt the wash sale rule by selling ETFs at a loss in a taxable investment account and then causing your tax-deferred account, such as an IRA, to acquire the same ETF shares within the wash sale period.

The loss that is disallowed under the wash sale rule does not disappear forever. You can adjust the basis of the newly acquired shares to reflect the loss that cannot be claimed now so that you can take it later, when you sell these shares.

Special treatment for certain ETF losses

Currency ETFs do not generate capital gains or losses, but rather ordinary income or losses. This means that losses on the sale of shares in these ETFs produce ordinary losses that can be used to offset ordinary income, such as wages and bank interest.

Conclusion

ETFs are acquired with the expectation of realizing an economic gain. However, if the price of the shares declines, investors may make a financial decision to take losses. Work with a knowledgeable tax advisor to optimize the effect of these losses.

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Article copyright 2011 by J.K. Lasser Tax Institute. Reprinted and adapted from J.K. Lasser’s Your Income Tax 2012 with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint.
The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.
The tax information contained herein is general in nature, is provided for informational purposes only, and should not be considered legal or tax advice. Fidelity does not provide legal or tax advice. Fidelity cannot guarantee that such information is accurate, complete, or timely. Laws of a specific state or laws that may be applicable to a particular situation may affect the applicability, accuracy, or completeness of this information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Always consult an attorney or tax professional regarding your specific legal or tax situation.
ETFs may trade at a discount to their NAV and are subject to the market fluctuations of their underlying investments. ETFs are subject to management fees and other expenses.
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