Substantially Identical
Substantially Identical Securities
This page seeks to define “substantially identical securities” in such a way that you can use the information to defend your position before the Internal Revenue Service. Remember, you are assumed to be liable for an assessed tax and it is up to you to prove that you are not, in other words, guilty until proven innocent.
The most “sure-fire” method never to be in a wash sale position is never to have losses … anyway … back to reality …
What is the purpose of the wash sale rule?
Congress enacted Internal Revenue Code (IRC) Sec 1091(a) to prevent investors (and traders) from deducting losses on the sale of a security position and then immediately re-entering the position in order to participate in it’s price increase. Essentially it is a timing issue and prevents the wide manipulation of taxable income.
It is important to note that mark-to-market traders and those trading in commodity futures contracts and foreign currencies are not subject to the wash sale rule.
But you want to take a loss and still have your “hand in the game”.
What about using options to continue your position?
Unfortunately, according to IRC Sec 1091(a), stock options are considered securities for the purpose of this Code section. Here’s what it says …
IRC Sec 1091(a)
In the case of any loss claimed to have been sustained from any sale or other disposition of shares of stock or securities where it appears that, within a period beginning 30 days before the date of such sale or disposition and ending 30 days after such date, the taxpayer has acquired (by purchase or by an exchange on which the entire amount of gain or loss was recognized by law), or has entered into a contract or option so to acquire, substantially identical stock or securities, then no deduction shall be allowed under section 165 unless the taxpayer is a dealer in stock or securities and the loss is sustained in a transaction made in the ordinary course of such business. For purposes of this section, the term “stock or securities” shall, except as provided in regulations, include contracts or options to acquire or sell stock or securities. (Emphasis mine)
For purposes of this section, the term “stock or securities” shall ... include contracts or options to acquire or sell stock or securities
entered into a contract or option so to acquire, substantially identical stock or securities
So, as reflected in the second emphasized section, options to acquire or options to sell stock are considered securities. That means that if an option is sold at a loss and then replaced - same underlying, same strike price and same expiration - it is included in the wash sale rule.
Now, we must interpret what a “contract or option so to acquire, substantially identical stock or securities” means. The term is not defined in the Code or the Regulations.
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Congressional intent was that an investor/trader could not simultaneously recognize a taxable loss and also participate in the upside of the security.
Thus, utilizing an option contract that grants the investor/trader the right or obligation to acquire a substantially identical stock or security would potentially trigger wash sale treatment. So what type of option grants the right or obligation to acquire the security?
Long calls - grant the right potentially to acquire the security.
Short puts - obligate the writer potentially to acquire the security.
Let’s look at some examples:
Example 1
You sell 100 shares of GOOGL on Dec 1 for $765 per share that you purchased for $835. You have a $7,000 capital loss. On Dec 30 you (purchase) BTO 1 GOOGL Mar 850 Call option. The price of GOOGL is $800 when you BTO the call.
Answer 1: You have triggered a wash sale on the date of purchase because you have entered into a contract to acquire substantially identical stock, regardless of the price of GOOGL at the time.
Answer 2a: You have potentially triggered a wash sale but you have to wait until expiration (Mar) to determine if the contract to acquire substantially identical stock is in the money. The inevitable question is how long do you have to wait? If the expiration is next month then 28-35 days. But what if you purchase a LEAPS call that does not expire for two years … would you have to wait two tax periods to determine if the LEAPS is substantially identical?
Answer 2b: You have potentially triggered a wash sale but you have to wait 30 days and then if the purchased option is ITM - regardless of the option’s expiry - you have acquired substantially identical stock, but if the long call is not ITM, no wash sale treatment is triggered.
Answer 3: You have not triggered a wash sale because the call is not ITM and there is no guarantee that it will be ITM by expiration and you only have the right to purchase if the option is ITM at expiration (before expiration with American-style) options.
Example 2
You sell 100 shares of GOOGL on Dec 1 for $765 per share that you purchased for $835. You have a $7,000 capital loss. On Dec 30 you sell) STO 1 GOOGL Mar 750 Put option. The price of GOOGL is $800 when you STO the put.
Answer 1: You have triggered a wash sale because you have entered into a contract that obligates you to purchase the underlying security if the price continues to drop.
Answer 2a: You have potentially triggered a wash sale depending on where the stock price is relative to the strike price when you STO the put. In this case the the short put is OTM (strike of 725 and current price of $730). At this point there is no obligation.
Answer 2b: You have potentially triggered a wash sale depending on where the stock price is relative to the strike price when you STO the put. Let’s say that in this case the the short put is ITM (strike of 750 and current price of $730). At this point an obligation exists to purchase the underlying stock.
Answer 3: You have not triggered a wash sale because the short put is OTM and no obligation has been created. There is no guarantee that the option will expire ITM. Therefore, strike price is important!!
Example 3 (Important to Option Traders)
What if you are trading a bearish vertical position, ie, a Bear Call, and the stock begins to trend upward? If you close your Bear Call and open a Bull Call, can you trigger a wash sale?
If you roll the position - keeping in mind that strategies are not taxed, the individual options are - you are virtually guaranteed a loss on the lower strike/originally sold call. When you roll the position up and out, you have four transactions, of which, the BTC of the original short call (at a loss) followed by the BTO of the lower strike long call when you roll is at issue. The other transactions, the STC followed by the STO of the call does not create a loss. Thus, is the loss on the BTC of the original short call a wash sale because of the purchase of the lower strike call on the roll?
A diagram may help visualize the trade. I am using RIMM (now BBRY) back in Jan/March of 2011 to illustrate the point.
Chart courtesy of thinkorswim by TD Ameritrade
Key Issue: Is this a Wash Sale?
So the question becomes, does the BTC - at a loss of $1.73 - of the Feb 11 62.50 Call become a wash sale at the BTO of the Mar 11 65.00 Call?
More specifically, is the RIMM Mar 11 65.00 Call a “substantially identical security” to the RIMM Feb 11 62.50 Call?
As stated above, the Internal Revenue Code and the Regulations do not define “substantially identical property” or “substantially identical securities” except to state in Regs Sec 1.1233 (pertaining to short sales) that it is to be applied on a facts and circumstances basis and Regs Sec 1.1091 is silent on the definition.
Since the intent of Congress was that taxpayers could not enjoy a tax loss while participating in the gain, does the RIMM Mar 11 65.00 Call participate in the gain to the same degree as the 62.50 Call? I would think not, unless RIMM finishes above $65 at expiration.
Example 4
Can wash sale treatment be triggered when a stock, such as AAPL, is sold at a loss but you are bullish on technology in general and you replace the position with QQQ? AAPL is the largest component of QQQ and influences its movement significantly.
QQQ, because the great majority of its components can nullify AAPL, would not be considered a “substantially identical security.” Even though AAPL comprises 11.59% of QQQ (as of the date of this writing), it can still move up while AAPL is moving down.
Conclusions
Known with Certainty
Here are the issues we know that will trigger the wash sale rule because the replacement security is “substantially identical”:
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Selling/covering a stock for a loss and replacing the same stock within the 61-day window.
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Selling/covering an option for a loss and replacing it with the same option within the 61-day window. The “same option” in this context would mean replacing a GE Jan 2018 30 Call, for example, with exactly the same call - another GE Jan 2018 30 Call.
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Since option trading has become a mainstream investment activity, there are many options to choose from among a single underlying, based simply on expiration and strike.
And this is where “facts and circumstances” enter …
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Similar Options (same strike)
Arguably, an IBM Mar 17 160 Call is substantially identical to an IBM Apr 17 160 Call. They are a month apart but will move almost identically with the movement of the underlying and participate almost identically with each other based on intrinsic value. If you BTO and then STC the Mar 17 160 at a loss, then BTO the Apr 17 160, you potentially have a wash sale on the Mar 17 160, but, only until the expiration of the Apr 17 call. Then you are out of the position within the same taxable year. So, this would only be a problem when creating the loss in December.
Now, the reason you have a loss on the Mar 17 160 call is because the underlying is increasing. What if you cover (BTC) the Mar 17 160 call at a loss and then sell (STO) the Apr 17 160 put? Is this a wash sale?
Let’s review the rules:
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Do we have the right to acquire the stock? No
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Do we have the obligation to acquire the stock? Potentially
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Is the obligation fixed at this point? No, it depends on the price of the underlying at expiration. In our example, IBM is moving upward and the 160 call was covered at a loss. If IBM was above 160 we have no obligation to acquire the stock.
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Do we participate in the underlying’s movement? No; take a look at the two risk profiles at the left. Once the short put is sold, that premium is all that will be received. If IBM shoots straight up to 300 the short put seller receives no further premium. It does not participate in the movement of the underlying.
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If the stock declines during the 30-day period after the covering transaction that created the loss, do we acquire substantially identical securities? Yes; we then are obligated to purchase IBM at 160.
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Therefore, with this type of transaction, it is essential to wait until the 30-day window - subsequent to the loss transaction - to determine if, in fact, a wash sale has occurred.
Different Options
It is my opinion, given the different components of option prices, ie, strike price, expiration, delta, theta and implied volatility, a very compelling case can be made that most options on the same underlying are NOT substantially identical.
We have seen above that the same strike price but different expirations would lean toward being substantially identical securities because they share a number of very similar characteristics, except expiration.
If you have studied the Greeks on your own, you know that option characteristics change dramatically based upon price of the underlying versus strike price (OTM, ATM, ITM), expiration and volatility.
Before the AAPL 7:1 split, I was trading a weekly 505/500 bull put on AAPL that I thought would simply be a dull trade where I received about $110 premium and went on my way. But on Friday expiration, AAPL dropped over 20 points and into my short position and then bounced up closing about 4 points above my short put. Literally within 15 minutes I went from a $400 loss to a winning trade. And it was based solely on the movement of the price of the short put (the 505); the long put (the 500), just one strike below, did not change much at all. Implied volatility also played a major role in the price of the short.
I believe a trader could successfully argue, using the Greeks and an options pricing model, especially with my above example, that the AAPL 505 put was very dissimilar to the 500 put and therefore not substantially identical.
Final Points
This is truly a facts and circumstances issue when dealing with various options as substantially identical to stock or other options.
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I don’t believe you will be selected for audit based solely upon wash sale issues. It will be discovered during an audit of other Schedule D factors, such as showing less gross proceeds on the Schedule D than was reported to IRS on the 1099-B, or higher cost basis now without proper adjustments.
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If you prepare your own Form 8949/Schedule D, make sure you use the procedures outlined in the Do-It-Yourself section. This is a very complicated area of taxation and you will need to consistently and accurately apply the rules in order to avoid any accuracy-related penalties - which can be substantial.