What Are Substantially Identical Mutual Funds?

Watch out for the wash sale rule when taking investment tax losses.

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If you sell an investment -- such as a mutual fund -- for a loss, the tax rules let you use that loss as a write-off. However, the Internal Revenue Service does not allow investors to game the tax rules by selling a security for the loss and then buying it right back -- a wash sale. Wash sales losses will be disallowed, and the purchase, if it is a substantially identical investment, can trigger a wash sale. With mutual funds, determining substantially equal can be a little tricky.

Wash Sale Rule

The wash sale rule states that if you sell investment for a loss, the loss will be disallowed if you buy that security or one that is substantially identical within the period 30 days before and after the date of the sale. So if you sold a mutual fund investment for a loss and bought that same fund within the 61-day window, your loss would be disallowed as a write-off. You do not lose the loss entirely. It will be included in the cost basis of the replacement investment.

Substantially Equal

The wash sale rule has been refined to rule out the tricks investors may use to get around the rule. One is that a substantially equal investment cannot be purchased within the wash sale window. An example of substantially equal would be selling a stock and buying call options on the same stock. The rule applies if you use another account such as your IRA or a spouse's account to buy the security.

IRS on Mutual Funds

Unlike many other types of securities, the IRS has not given clear guidelines about what would be viewed as substantially identical if a mutual fund is sold and another mutual fund is purchased within the wash sale window. Investment advisors and tax planners recommend against selling an index mutual fund from one fund company and buying another index fund tracking the same stock index from another mutual fund company.

Avoiding a Wash Sale

An article by Lee C. McGowan, CFP in the Journal for Financial Planning gives some guidelines concerning replacement mutual funds and the substantially equal restriction. The article suggest that the following transactions should not trigger a wash sale: Selling an index fund and buying an actively managed fund. Selling an actively managed fund and buying an index fund. Selling an index fund and buying an index fund tracking a different stock index. Selling an actively managed fund and buying a fund managed by a different fund company and manager.