A Day Trader and Wash Losses

 

We have had a difficult time with the tax return of someone who dove into the deep end of the day-trading pool last year. The year-end Fidelity statement reported the trades, but the calculation of gain and losses was way off. The draft return landed on my desk showing a wash loss of about $2.5 million. Problem: the client was trading approximately $250 grand in capital. She would have known if she lost $2.5 million as either she (1) would have had a capital call, (2) used margin, or (3) done a bit of both.

Let’s talk about wash sales.

The rule was created in 1921 because of a too-favorable tax strategy.

Let’s say that you own a stock. You really believe in it and have no intention of parting with it. You get near the end of the year and you are reviewing your to-date capital gains and losses with your advisor. You have $5 thousand in capital gains so far. That stock you like, however, took a dip and would show a $4 thousand loss … if you sold it. The broker hatches a plan.

“This is what we will do” says the broker. We will sell the stock on December 30 and buy it back on January 2. You will be out of the stock for a few days, but it should not move too much. What it will do is allow us to use that $4 thousand loss to offset the $5 thousand gain.”

It is a great plan.

Too great, in fact. Congress caught wind and changed the rules. If you sell a stock at a loss AND buy the same or substantially identical stock either

·      30 days before or

·      30 days after …

… the sale creating the loss, you will have a wash sale. What the tax law does is grab the loss ($4 thousand in our example) and add it to the basis of the stock that you bought during the 30 day before-and-after period. The loss is not permanently lost, but it is delayed.

Mind you, it only kicks-in if you sell at a loss. Sell at a gain and the government will always take your money.

Let’s go through an example:

·      On June 8 you sell 100 shares at a loss of $600.

·      On July 3 you buy 100 shares of the same stock.

You sold at a loss. You replaced the stock within the 61-day period. You have a wash loss. The tax Code will disallow the $600 loss on the June 8 trade and increase your basis in the July 3 trade by $600. The $600 loss did not disappear, but it is waiting until you sell that July 3 position.

Problem: you day trade. You cannot go 48 hours without trading in-and-out of your preferred group of stocks.

You will probably have a lot of wash sales. If you didn’t, you might want to consider quitting your day job and launching a hedge fund.

Problem: do this and you can blow-up the year-end tax statement Fidelity sends you. That is how I have a return on my desk showing $2.5 million of losses when the client had “only” $250 grand in the game.

I want to point something out.

Let’s return to our example and change the dates.

·      You already own 100 shares of a stock

·      On June 8 you buy another 100 shares

·      On July 3 you sell 100 shares at a loss

This too is a wash. Remember: 30 days BEFORE and after. It is a common mistake.

The “substantially identical” stock requirement can be difficult to address in practice. Much of the available guidance comes from Revenue Rulings and case law, leaving room for interpretation. Let’s go through a few examples.

·      You sell and buy 100 shares of Apple. That is easy: wash sale.

·      You sell 100 shares of Apple and buy 100 shares of Microsoft. That is not a wash as the stocks are not the same.

·      You sell 30-year Apple bonds and buy 10-year Apple bonds. This is not a wash, as bonds of different maturities are not considered substantially identical, even if issued by the same company.

·      You sell Goldman Sachs common stock and buy Goldman Sachs preferred. This is not a wash, as a company’s common and preferred stock are not considered substantially identical.

·      You sell 100 shares of American Funds Growth Fund and buy 100 shares of Fidelity Growth Company. The tax law gets murky here. There are all kinds of articles about portfolio overlap and whatnot trying to interpret the “substantially identical” language in the area of mutual funds.  Fortunately, the IRS has not beat the drums over the years when dealing with funds. I, for example, would consider the management team to be a significant factor when buying an actively-managed mutual fund. I would hesitate to consider two actively-managed funds as substantially identical when they are run by different teams. I would consider two passively-managed index funds, by contrast, as substantially identical if they tracked the same index.  

·      You sell 100 shares of iShares S&P 500 ETF and buy the Vanguard S&P 500 ETF.  I view this the same as two index mutual funds tracking the same index: the ETFs are substantially identical.

·      Let’s talk options. Say that you sell 100 shares of a stock and buy a call on the same stock (a call is the option to buy a stock at a set price within a set period of time). The tax Code considers a stock sale followed by the purchase of a call to be substantially identical.

·      Let’s continue with the stock/call combo. What if you reverse the order: sell the call for a loss and then buy the stock? You have a different answer: the IRS does not consider this a wash.

·      Staying with options, let’s say that you sell 100 shares of stock and sell a put on the same stock (a put is the option to sell a stock at a set price within a set period of time). The tax consequence of a put option is not as bright-line as a call option. The IRS looks at whether the put is “likely to be exercised,” generally interpreted as being “in the money.”

Puts can be confusing, so let’s walk through an example. Selling means that somebody pays me money. Somebody does that for the option of requiring me to buy their stock at a set price for a set period. Say they pay me $4 a share for the option of selling to me at $55 a share. Say the stock goes to $49 a share. Their breakeven is $51 a share ($55 minus $4). They can sell to me at net $51 or sell at the market for $49.  Folks, they are selling the stock to me. That put is “in-the-money.”  

Therefore, if I sell a put when it is in-the-money, I very likely have something substantially identical.

There are other rules out there concerning wash sales.

·      You sell the stock and your spouse buys the stock. That will be a wash.

·      You sell a stock in your Fidelity account and buy it in your Vanguard account. That will be a wash.

·      You sell a stock and your IRA buys the stock. All right, that one is not as obvious, but the IRS considers that a wash. I get it: one is taxable and the other is tax-deferred. But the IRS says it is a wash. I am not the one making the rules here.

·      There is a proportional rule. If you sell 100 shares at a loss and buy only 40 shares during the relevant 61-day period, then 40% (40/100) of the total loss will be disallowed as a wash.

Let’s circle back to our day trader. The term “trader” has a specific meaning in the tax Code. You might consider someone a trader because they buy and sell like a madman. Even so, the tax Code has a bias to NOT consider one a trader. There are numerous cases where someone trades on a regular, continuous and substantial basis – maybe keeping an office and perhaps even staff - but the IRS does not consider them a trader. Maybe there is a magic number that will persuade the IRS - 200 trading days a year, $10 million dollars in annual trades, a bazillion individual trades – but no one knows.

There is however one sure way to have the IRS recognize someone as a trader. It is the mark-to-market election. The wash loss rule will not apply, but one will pay tax on all open positions at year-end. Tax nerds refer to this as a “mark,” hence the name of the election.

The mark pretends that you sold everything at the end of the year, whether you actually did or did not. It plays pretend but with your wallet. This tax treatment is different from the general rule, the one where you actually have to sell (or constructively sell) something before the IRS can tax you.

Also, the election is permanent; one can only get out of it with IRS permission.

A word of caution: read up and possibly seek professional advice if you are considering a mark election. This is nonroutine stuff – even for a tax pro. I have been in practice for over 35 years, and I doubt I have seen a mark election a half-dozen times.

Sell Today And Pay Tax in Thirty Years

Sometimes I am amazed to the extent people will go to minimize, defer or avoid taxes altogether.

I get it, though. When that alarm clocks goes off in the morning, there is no government bureaucrat there to prepare your breakfast or drive you to work. Fair share rings trite when yours is the only share visible for miles.

I am looking at an IRS Chief Council Advice.

Think of the Chief Counsel as the attorneys advising the IRS. The Advice would therefore be legal analysis of an IRS position on something.

This one has to do with something called Monetized Installment Sale Transactions.

Lot of syllables there.

Let’s approach this from the ground floor.

What is an installment sale?

This is a tax provision that allows one to sell approved asset types and spread the tax over the years as cash is collected. Say you sell land with the purchase price paid evenly over three calendar years. Land is an approved asset type, and you would pay tax on one-third of your gain in the year of sale, one-third the following year and the final third in the third year.

It doesn’t make the gain go away. It just allows one to de-bunch the taxation on the gain.

Mind you, you have to trust that the buyer can and will pay you for the later years. If you do not trust the buyer’s ability (or intention) to do so, this may not be the technique for you.

What if the buyer pays an attorney the full amount, and that attorney in turn pays you over three years? You have taken the collection risk off the table, as the monies are sitting in an attorney’s escrow account.

You are starting to think like a tax advisor, but the technique will almost certainly not work.

Why?

Well, an easy IRS argument is that the attorney is acting as your agent, and receipt of cash by your agent is the equivalent of you receiving cash. This is the doctrine of “constructive receipt,” and it is one of early (and basic) lessons as one starts his/her tax education.

What if you borrow against the note? You just go down to Fifth Third or Truist Bank, borrow and pledge the note as collateral.

Nice.

Except that Congress thought about this and introduced a “pledging” rule. In short, a pledge of the note is considered constructive receipt on the note itself.

Not to be deterred, interested parties noticed a Chief Council’s Memorandum from 2012 that seemed to give the OK to (at least some of) these transactions. There was a company that need cash and needed it right away. It unloaded farm property in a series of transactions involving special purpose entities, standby letters of credit and other arcane details.

The IRS went through 11 painful pages of analysis, but wouldn’t you know that – at the end – the IRS gave its blessing.

Huh?

The advisors and promoters latched-on and used this Memorandum to structure future installment sale monetization deals.

Here is an example:

(1)  Let’s say I want to sell something.

(2)  Let’s say you want to buy what I am selling.

(3)  There is someone out there (let’s call him Elbert) who is willing to broker our deal – for a fee of course.

(4)  Neither you or I are related to Elbert or give cause to consider him our agent.

(5)  Elbert buys my something and gives me a note. In our example Elbert promises to pay me interest annually and the balance of the note 30 years from now.

(6)  You buy the something from Elbert. Let’s say you pay Elbert in full, either because you have cash in-hand or because you borrow money.

(7)  A bank loans me money. There will be a labyrinth of escrow accounts to maintain kayfabe that I have not borrowed against my note receivable from Elbert.

(8)  At least once a year, the following happens:

a.    I collect interest on my note receivable from Elbert.

b.    I pay interest on my note payable to the bank.

c.    By some miraculous result of modern monetary theory, it is likely that these two amounts will offset.

(9)  I eventually collect on Elbert’s note. This will trigger tax to me, assuming someone remembers what this note is even about 30 years from now.

(10)      Having cash, I repay the bank for the loan it made 30 years earlier.

There is the monetization: reducing to money, preferably without taxation.

How much of the original sales price can I get using this technique?

Maybe 92% or 93% of what you paid Elbert, generally speaking.

Where does the rest of the money go?

Elbert and the bank.

Why would I give up 7 or 8 percent to Elbert and the bank?

To defer my tax for decades.

Do people really do this?

Yep, folks like Kimberly Clark and OfficeMax.

So what was the recent IRS Advice that has us talking about this?

The IRS was revisiting its 2012 Memorandum, the one that advisors have been relying upon. The IRS lowered its horns, noting that folks were reading too much into that Memorandum and that they might want to reconsider their risk exposure.

The IRS pointed out several possible issues, but we will address only one.

The company in that 2012 Memorandum was transacting with farmland.

Guess what asset type is exempt from the “pledging” rule that accelerates income on an installment note?

Farmland.

Seems a critical point, considering that monetization is basically a work-around the pledging prohibition.

Is this a scam or tax shelter?

Not necessarily, but consider the difference between what happened in 2012 and how the promoters are marketing what happened.

Someone was in deep financial straits. They needed cash, they had farmland, and they found a way to get to cash. There was economic reality girding the story.   

Fast forward to today. Someone has a big capital gain. They do not want to pay taxes currently, or perhaps they prefer to delay recognizing the gain until a more tax-favorable political party retakes Congress and the White House. A moving story, true, but not as poignant as the 2012 story.   

For the home gamers, this time we have been discussing CCA 2019103109421213.

How To Forfeit an IRS Collection Due Process Hearing

I am looking at a Tax Court case.

I presume it was an act of desperation by the taxpayer, otherwise it makes no sense.

Let’s say that you get yourself into a quarter million dollars of tax debt.

You know the Collection bus is coming. You probably should get ahead of it, but it escapes your attention.

You receive IRS notice LT-11.

You are in the Collections sequence.

Let’s talk about the general order of tax collection notices.

   CP-14      Balance Due

   CP-501    Reminder Notice 

   CP-503    Reminder Notice

   CP-504    Notice of Intent to Levy

   LT-11       Notice of Intent to Levy and Notice of Your 

                   Right to a Hearing

Some observations:

First, you are deep into the machinery at this point. There were at least 4 notices sent to you before you received this one.

Second, a levy means that someone is going to take your stuff. This is different from a lien. The IRS can put a lien on your house, as an example. The lien will sit there, damaging your credit along the way, but it will not spring to action until you sell the house. A levy is not so nice. The IRS can drain your bank account with a bank levy, or it can divert (some of) your paycheck with a wage levy.

Third, you have taxpayer rights in response to receiving a LT-11, but there is a time limit. If you respond within 30 days you have full rights; respond after 30 days and you have lesser rights.  Granted, depending on the situation, it may be that both the 30 and 30-plus varieties will have all the rights you need.

You may wonder what the difference is between the CP-504 Notice of Intent to Levy and the LT-11 Notice of Intent to Levy. It is confusing. I wish the IRS used different wording on these notices, but it is what it is.

The difference is the type of Collections rights the taxpayer has. Both the CP-504 and LT-11 give you rights, but the rights under the LT-11 are more expansive.

An appeal under a CP-504 is referred to as Collection Appeal Program (CAP). An appeal under a LT-11 is referred to as Collection Due Process (CDP). There are differences between the two, and a huge difference is that the CAP is non-appealable whereas the CDP is.

If you want the safety net of a possible appeal, you are waiting until the LT-11.

BTW do not assume that all CPAs know this notice sequence and its significance. All CPAs have had some tax education, but not all CPAs practice tax or – more importantly – practice tax procedure to any meaningful extent. Tax procedure is rarely taught in school, and – to a great extent – it is learned through mentoring and practice.  

Our protagonist (Ramey) had several businesses, and he used the same address for all of them. There were other businesses at this address, so I presume we are talking about a shared office space facility. Anyway, the IRS sent the LT-11 notice, return receipt requested. The notice was delivered and someone signed the receipt, but that someone was not Ramey’s employee.

At this point, I am thinking: no big deal.

There is a 30-day time limit if one wants to request a CDP. The 30 days lapsed.

Oh, oh.

Mind you, there is a fallback option if one exceeds 30 days, but the downside is that any decision under the fallback is non-appealable.

Ramey wanted the option to appeal.

He figured he had a card left to play.

The IRS notice has to meet several requirements under Section 6330 before the IRS can actually levy. The notice has to be:

(1)  Given in person;

(2)  Left at the dwelling or usual place of business; or

(3)  Sent by certified or registered mail, return receipt requested, to such person’s last known address.

Ramey argued that he had not signed for the mail, and the person who did sign did not have authority to sign on his behalf.

Seems like weak tea.

The Court agreed:

Mr. Ramey’s chief complaint appears to be that multiple businesses use that address, so mail might be accepted by the wrong person. But, even if that is so, Mr Ramey does not explain how the IRS could have taken this fact into account. Mr Ramey is free to organize his business affairs as he sees appropriate, including by choosing to share a business address with other businesses. But, having made that choice, and having provided the IRS an address shared by multiple businesses, he cannot properly complain when the IRS uses that very address to reach him.”

Ramey blew the 30- day window. He failed to protect his right to appeal to the Tax Court.

The Court correctly pointed out that Ramey still had options. He could, for example, pay the underlying tax, request a refund, and appeal the denial of that refund request in District Court, for example.

So why the fuss about the 30 days?

One does not have to pay the tax before being allowed to file in Tax Court. One however does have to pay the tax in order to file with a District Court or the Court of Federal Claims.

Ramey owed a quarter of a million dollars.

Our case for the home-gamers was Ramey v Commissioner 156 T.C. No. 1.