ETF Wash Sale Rules: How They Impact Taxes and Investments

Tax rules can be tricky, and one that often catches investors off guard is the wash sale rule. This IRS regulation prevents taxpayers from claiming a loss on a security if they buy a “substantially identical” investment within 30 days before or after selling it at a loss. Originally designed for stocks, the rule also applies to exchange-traded funds (ETFs), complicating tax planning for frequent traders.

Understanding how ETFs are affected by the wash sale rule helps investors avoid losing tax deductions and ensures compliance with IRS regulations. Proper planning can prevent costly mistakes and unexpected tax liabilities.

How ETFs Fit Into Wash Sale Rules

ETFs fall under the same wash sale restrictions as individual stocks. If an investor sells an ETF at a loss and repurchases the same fund within 30 days, the IRS disallows the loss for tax purposes. Instead, the disallowed loss is added to the cost basis of the new shares, deferring the tax benefit rather than eliminating it.

This rule is particularly relevant for investors using tax-loss harvesting, a strategy that offsets capital gains by selling losing positions. If a replacement purchase triggers a wash sale, the expected tax benefit is deferred, complicating tax planning.

Frequent ETF traders and those using automated investment platforms must be especially careful. Many robo-advisors automatically reinvest dividends or rebalance portfolios, potentially triggering wash sales without the investor realizing it. The IRS applies wash sale rules across all taxable accounts an investor owns, meaning transactions in different accounts can still result in a wash sale.

Identifying Substantially Identical Funds

Determining whether two ETFs are “substantially identical” is one of the biggest challenges of the wash sale rule. The IRS does not provide a precise definition, leaving investors to assess whether two funds are too similar.

ETFs tracking the same index, such as the S&P 500, often hold nearly identical securities. Selling shares of the SPDR S&P 500 ETF (SPY) and buying the iShares Core S&P 500 ETF (IVV) within 30 days could trigger a wash sale since both funds follow the same benchmark and have nearly identical holdings. The same applies to ETFs tracking other major indices, such as the Nasdaq-100 or Russell 2000, where competing funds may have minor differences in expense ratios or fund managers but still hold the same stocks.

Sector and thematic ETFs also require scrutiny. Selling the Vanguard Information Technology ETF (VGT) and buying the Technology Select Sector SPDR Fund (XLK) could be considered a wash sale since both focus on large-cap tech stocks. However, ETFs with different weighting methodologies—such as equal-weighted versus market-cap-weighted funds—may have enough distinction to avoid wash sale classification.

The 30-Day Replacement Window

The IRS enforces a strict 30-day period before and after the sale of a losing position. Investors must wait at least 31 days to repurchase the same or a substantially identical ETF if they want to claim the loss for tax purposes. Any purchase within this timeframe results in the loss being deferred rather than immediately deductible.

This waiting period can be challenging for investors who want to maintain market exposure while harvesting losses. Sitting out of the market for 30 days can lead to missed gains if prices rebound. Some investors try to work around this by purchasing a similar but not identical ETF during the waiting period. For example, replacing an S&P 500 ETF with a total stock market ETF may provide broad market exposure while potentially avoiding the wash sale rule.

Cost Basis Adjustments

When a wash sale occurs, the disallowed loss is incorporated into the cost basis of the newly acquired ETF shares. This adjustment increases the tax basis of the replacement shares, reducing the taxable gain (or increasing the loss) when they are eventually sold.

Dividend reinvestment plans (DRIPs) and automatic purchases can create complications. If an investor reinvests ETF dividends and a wash sale is triggered, the disallowed loss is allocated to the reinvested shares, significantly increasing their cost basis. Over time, this can make tracking gains and losses more difficult, especially for frequent traders.

Recordkeeping Requirements

Tracking wash sales requires detailed recordkeeping. The IRS mandates cost basis adjustments when a wash sale occurs, so investors must maintain records of purchase and sale dates, transaction amounts, and adjusted basis calculations.

Brokerage firms provide transaction histories and cost basis adjustments, but these reports may not always capture wash sales across multiple accounts. If an investor holds ETFs in different taxable brokerage accounts, such as individual and joint accounts, wash sales can still apply even if the transactions occur separately. Investors must manually track these transactions to ensure compliance. Using tax software or spreadsheets can help consolidate data and prevent errors, particularly for those who trade frequently or reinvest dividends automatically.

Reporting on Tax Returns

Wash sales must be properly reported on tax filings. The IRS requires taxpayers to disclose wash sales on Form 8949, which details capital gains and losses. The adjusted basis of replacement shares should also be reflected in Schedule D to ensure future gains or losses are calculated correctly when those shares are sold.

Brokerage firms report wash sales on Form 1099-B, but only for transactions within the same account. If a wash sale occurs across multiple accounts or through dividend reinvestments, these adjustments may not appear on the 1099-B, requiring manual corrections. Failing to report wash sales accurately can lead to discrepancies with the IRS, potentially triggering audits or penalties. Investors who trade ETFs frequently should review their tax documents carefully and consider consulting a tax professional to avoid misreporting.