By Lewis Braham

Were you panicking when the S&P 500 fell 12% from April 2 to April 8 -- or were you planning your next tax moves?

This year's tariff-induced volatility has provided terrific opportunities to sell your losing stock positions to capture a tax write-off. Those losses can be used to offset taxable capital gains from winning positions -- or even to write off up to $3,000 from your personal income taxes if you have no gains to offset. And unused loss write-offs don't expire at year end. They can be banked in 2025 to offset gains in future years.

Yet you'll still want to buy replacement stocks or stock funds for the losers you sold to maintain your overall asset-allocation plan. The problem is that to get the write-off, the Internal Revenue Service prohibits investors from replacing a security with the same or a "substantially identical" investment 30 days before or after the sale -- what is known as the "wash-sale rule." So if you sell the SPDR S&P 500 exchange-traded fund, you can't buy it or another substantially identical S&P 500 ETF like Vanguard S&P 500 for at least 30 days, or the IRS will disallow the write-off.

Thirty days is a long time to be out of stocks in this roller-coaster market. If you sold your S&P 500 ETF on April 8 and did nothing else, you missed the comeback on April 9, when President Donald Trump paused some tariffs for 90 days and the index surged 9.5%. Yet if you substituted the S&P 500 ETF with, say, Vanguard Total Stock Market, which owns all of the S&P 500 stocks plus over 3,000 others, you would have harvested a capital loss but also gained 9.5% on April 9 as the total market ETF rose that much, too. The IRS should allow the write-off, as the two ETFs aren't identical.

One must use the phrase "should allow the write-off," as the IRS has never formally defined what "substantially identical" means with regard to substitutions. That makes it a judgment call. For instance, financial advisor Zach Palmer of Ark Royal Wealth Management in Charlotte, N.C., has recently been selling his clients' shares of Dimensional International Core Equity Market and replacing them with Dimensional International Core Equity 2 or Avantis International Equity. Portfolio "composition is extremely similar for all funds," he notes, and their performance is "highly correlated."

Advisor Brett Lozowski of Life Planning Partners in Jacksonville, Fla., is replacing losing funds with ones different enough not only to sidestep the wash-sale rule but to make tactical shifts to his clients' portfolios. He has been selling Vanguard Total Stock Market to buy Dimensional US Equity Market, which has more of a high-quality and value-stock focus than the broad index. He also sold iShares Short-Term National Muni Bond to buy Vanguard Tax-Exempt Bond. The Vanguard ETF invests in bonds with longer maturities and is thus more sensitive to interest-rate moves. "The swap was made to take advantage of higher interest rates with longer-term bonds," Lozowski says. Yet it "still maintains exposure to high credit quality tax-free bonds."

Volatility is actually the taxable investor's friend, as it allows greater loss realization and substitution opportunities. Individual stocks are generally more volatile than broadly diversified index funds. For this reason, the most tax-sensitive investors should consider direct indexing instead of ETFs.

Direct indexers such as Morgan Stanley's Parametric, BlackRock's Aperio, and Charles Schwab offer private accounts designed to mimic an investor's chosen index, holding many or all of the individual stocks in the index in each account. Managers have quantitative systems that analyze each losing stock to find a suitable replacement for it while still tracking the benchmark as closely as possible, minimizing what is known as tracking error.

Such swaps can get tricky, depending on the company. Substituting, say, Home Depot for Lowe's is straightforward, as both are similar companies and each represents less than 1% of the S&P 500. But what about Apple, which represents almost 7% of the index and is a unique company?

To swap for Apple, says Jeremy Milleson, Parametric's director of investment strategy, "we want to buy a basket of securities that is going to have a similar [combined] risk exposure. [They represent] the IT sector, the computer industry, megacap stocks and other risk characteristics." The firm won't sell such a large individual position all at once, but chip away at the shares with losses gradually.

The typical expense ratio for direct indexed accounts is about 0.40%, which can vary depending on the provider, the account size, and the complexity of the account's strategy. That's more than ETF fees, but ETFs don't provide what is called "tax alpha" to wealthy investors -- a return greater than index funds after taxes.

"We recommend that clients look at the tax alpha these products are going to produce for their tax situation, and make sure that the [direct account's] fee above an ETF's justifies that," says Ran Leshem, BlackRock's head of SMA Solutions, which oversees Aperio.

Historically, he says, direct indexing has added one to two percentage points a year to clients' returns after taxes.

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May 02, 2025 21:30 ET (01:30 GMT)

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