Every year around this time, we receive many inquiries about the tax treatment of wash sales. To help you gain a little more clarity on the topic, we’re providing an updated version of our “Wash Sales FAQ”:

What is a wash sale?
Under the Internal Revenue Code, a wash sale occurs when an investor sells a security and then repurchases the same security within 30 days of the date of the sale.

What is the effect of a wash sale?
Wash sales defer an investor’s ability to take a loss resulting from a sale of the investment. So if an investor sells an investment on February 1 at a loss of $3 and then buys the same investment back on February 15, the loss from that sale is not recognized (deducted from other income). Recognition of the loss would be delayed until a new sale occurs that is not within 30 days of a purchase (before or after).

Why is a wash sale treated this way?
Before the wash-sales rule entered the Internal Revenue Code, investors could artificially generate a capital loss by simply selling a stock that they had a loss on and buying it back a short time later. This allowed investors to reduce their taxable income by taking advantage of volatility at a time of their choosing, even though they had no intention of not remaining invested in the security. The wash-sales rule sought to eliminate what was deemed a tax-avoidance scheme.

Why is a wash sale not as bad as you might think?
First, the wash-sales rule only applies to losses taken outside of a tax-deferred vehicle. It does not apply to trades made within an IRA, 401(k), 403(b), or other qualified plans. It also does not apply to trades within a variable annuity (VA) or variable universal life policy.

Even if the trade is outside one of these deferred income vehicles,

  1. the use of the loss is not lost to the investor but is just deferred until the investor has a non-wash-sale trade;
  2. if that occurs within the same year, there is no impact on the investor’s taxes at all; and
  3. when the loss is deferred, the deferred loss is added to the cost of the investment, so that when there is a sale of the stock in a non-wash-sale trade, any gain is reduced by the amount of the earlier wash-sale loss. Similarly, if there is a loss, it is increased by the amount of the wash-sale loss foregone.

How do wash sales impact active management?
The likelihood of a wash sale depends on how frequently your manager trades. Many strategies trade essentially identical securities on a daily or weekly basis. Such strategies will by definition generate wash sales.

FPI strategies where this is the case are WP Income Builder, Government Bond Trading, Sector Index Rotation, Long/Short Government Bond, Managed Income Aggressive, Political Seasonality Index (all daily trading), and Fusion—including QFC Fusion 2.0 (weekly trading). The wash-sales treatment is the trade-off for using more frequent trading to provide downside protection and to seek more frequent profit opportunities.

In addition, tactical strategies, which move into and out of a single index fund or asset class, can have a whipsaw trade in which they buy and then reverse course in a short period. While this rarely happens in many of the tactical strategies (Volatility Adjusted NASDAQ, Self-adjusting Trend Following, Systematic Advantage, Trivantage, and Classic), contrarian or mean-reversion strategies (Contrarian S&P Trading and TVA Gold) are designed to have short-term trades, and this will occur with some regularity.

Four ways to avoid wash sales at Flexible Plan

  1. Trade the strategies previously mentioned first in your qualified accounts. None of these trades will be classified as a wash sale.
  2. Trade those strategies solely in a variable annuity (VA). Nationwide Monument Advisor is an especially good vehicle for this since they charge only $20 a month—no matter how big or small the account. So it’s $20 on a $1,000 account and also on a $1,000,000 account. It is truly one of the best deals on Wall Street—buying tax deferral for just $20 per month. And almost all of our strategies are available on this variable annuity.

I’ve heard some advisers say that this approach ignores the fact that distributions taken from a VA are subject to ordinary income-tax treatment, and they want to avoid such treatment. But with a VA you defer taxation on trades that occur before distribution and avoid dealing with wash sales. If you held the strategies outside of the VA in a taxable account, you would neither defer nor avoid, regardless of when you took money out of the account. Instead, you would have to deal with taxation and wash sales yearly. It’s especially great to be able to avoid both for just $20 per month.

  1. Use our 25 QFC strategies. All of the frequent trading with our QFC strategies is done within the mutual funds. Trades within a mutual fund are not subject to the wash-sale rule.

Reallocations of assets within the QFC strategies generally occur on a one-month-plus trading cycle, so they do not qualify for wash-sale treatment. Classic, Political Seasonality Index, and Systematic Advantage are subject to the whipsaw possibility previously discussed. QFC strategies, for the most part, have little chance of a wash sale—and they have a low, low advisory fee—a win-win!

  1. Restrict your strategies to our less-traded strategies. Our monthly trend-following strategies, such as Market Leaders, Lifetime Evolution, All-Weather, any of our Evolution specialty strategies, and our Principled Investing strategies (Faith Focused Investing and For A Better World) trade no more frequently than monthly. In this same vein, A Better Buy and Hold, and Low Volatility/Rising Dividends seek to have no short-term trades.

I know that any day now I will receive a call from a client, adviser, or accountant wanting to know about these wash sales showing up in a client account. Hopefully, the explanations in this article—combined with a little planning—will help.*

Market update

The major stock market indexes were mixed again last week, although three out of four indexes moved higher: The Dow Jones Industrial Average gained 0.66%, the S&P 500 Stock Index rose 0.94%, the NASDAQ Composite climbed 1.75%, and the Russell 2000 small-capitalization index lost 0.19%. The 10-year Treasury bond yield rose 3 basis points to 1.82%, sending bonds slightly lower. Last week, spot gold closed higher again at $1,562.34, up $10.14 per ounce, or 0.65%.

It continues to be a good time for gold investors. In fact, gold has been up for four straight years—and 16 of the last 20!

There was some weakness the last couple of days, but softness in the dollar evidenced by the first death cross (when the 50-day moving average closes below the 200-day moving average) since 2017 may help gold extend its winning streak into a fifth advancing year. Additionally, Goldman Sachs opined that gold showed itself to be the best hedge during the recent global uncertainty.

Flexible Plan Investments, Ltd., is the subadvisor of the nation’s only mutual fund designed to track the daily changes in the price of gold (The Gold Bullion Strategy Fund, QGLDX). The Fund is also available on a tax-deferred basis at Nationwide’s low-cost Monument Advisor variable annuity. Our QFC TVA Gold strategy trades the Fund in a manner designed to mitigate the volatility of an investment in the yellow metal. It registered double-digit gains last year after maximum fees.

Conversely, Treasury bonds continue to trend lower. We saw an attempt at a rally last week, but it seemed to end Monday (1/13). With the U.S. economy seeming to heat up, the decline in bonds and a corresponding move higher in interest rates seem likely to continue.

We have seen some discouraging economic reports in the last week following the dismal ISM manufacturing index report a week ago Friday. That was followed by a lower-than-expected payroll report and a decline in durable goods orders.

Offsetting these reports, unemployment claims fell to an almost 50-year low and the ISM’s non-manufacturing service index soundly beat expectations.

While the Citi surprise index has been languishing in negative territory for the better part of the last year (indicating that most economic reports have failed to beat expert expectations), it has been rallying and has now pushed slightly into the positive zone.

The economic reports scheduled to be released this week are major and hold the potential of roiling the markets. Tuesday we will see the first of the inflation measures with the reporting of the consumer price index. Wednesday we will see a retail sales report, followed by the University of Michigan Consumer Sentiment Index report on Friday.

I expect that we will see a phase-one trade agreement between the U.S. and China signed this week as well. The latest report on Chinese imports into the U.S. shows a 30% decline since 2018, which puts pressure on the Chinese to come to the bargaining table.

At the same time, the fourth-quarter earnings reporting season starts this week with many of the big banks and financial-services firms leading the way. The reporting season continues for six weeks, peaking during the last week of this month and the first week of February.

There has been only a slightly negative tone to analyst earnings ratings over the last four weeks. However, as we have pointed out in the past, negativity among analysts has usually translated into positive performance in the S&P 500 during the next six weeks. As Bespoke Investment Group reports, “In the 17 prior earnings seasons since 2009 where the spread has been in the single-digit negative percentage range as it is now (-4.1%), the S&P 500 has seen a median gain of 1.16% with positive returns fourteen times.”

However, our Political Seasonality Index points to last Monday’s (1/6) close as a short-term January top, before turning lower until month’s end. (Our Political Seasonality Index is available post-login in our Solution Selector under the Domestic Tactical Equity category.) At the same time, the period of overly optimistic market sentiment seems to be waning. Investors have so far survived some near-historic levels of optimism on many indicators. Still, the so-called fear index remains at short-term lows normally indicative of complacency as it has no place to go now but up.

Meanwhile, the S&P 500 continues to be substantially overbought. This often is cited as portending a period of short-term weakness; however, with the S&P 500 spending 95% of the last 50 days in overbought territory, the market may be so bad that it is good. Looking at the historical record during overbought times like these, the S&P 500 back to 1928 has been up about 70% of the time over the next 1, 3, 6, and 12 months.

FPI intermediate-term tactical strategies are positively situated: The Volatility Adjusted NASDAQ strategy (VAN) remains at 140% invested, Classic continues to be fully invested, and our Self-adjusting Trend Following strategy (STF) remains at 200% invested. VAN and STF both employ leverage—hence the investment positions of more than 100%.

Short-term indicators remain mixed. Our QFC S&P Pattern Recognition strategy’s equity exposure continues to be slightly negative.

Among the Flexible Plan Market Regime indicators, our Growth and Inflation measure still shows that we are in a Normal economic environment (meaning a positive inflation rate and positive GDP). Our Volatility composite (gold, bond, and stock market) is now showing a Low and Falling reading, which favors stocks and then gold over bonds—although all have positive returns in this regime stage.

I’m looking for short-term weakness to sideways action in stocks, but remain long-term bullish.

All the best,

Jerry

*While Mr. Wagner was a practicing tax attorney, Flexible Plan Investments does not provide tax advice. Readers are encouraged to seek the counsel of their own qualified tax accountant or attorney on these matters.

Jerry C. Wagner is Founder and President of Flexible Plan Investments, Ltd. Formerly a tax and securities attorney, Mr. Wagner recognized early on that technology and hedge fund techniques could be applied to help individuals successfully invest, while managing their downside risk. After spending time pioneering new techniques in market analysis, designing quantitative methodologies, and managing investment portfolios, Mr. Wagner founded Flexible Plan Investments in February 1981.

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