LeAnn Luna

Tax Issues Arising From Stock Market Declines

Investors have suffered during 2008, but the tax code provides opportunities for both greed and caution after the fall.

December 11, 2008
by LeAnn Luna

Warren Buffett stated recently in The New York Times, “Be fearful when others are greedy, and be greedy when others are fearful.” This article addresses tax issues arising from stock market declines. Specifically, it addresses 1) Wash Sale rules, 2) IRA to Roth conversions and 3) AMT relief for taxpayers who exercised incentive stock options.

Wash Sales Rules (IRC Sec. 1091)

Many investors know that if they sell a stock at a loss, the capital loss is not deductible if they repurchase the same stock within 30 days of the sale. The nondeductible loss adds to the basis of the new shares and will be recognized when an allowable sale occurs. However, a couple of frequent questions might still arise. For example, can an investor avoid the wash sale rules if the investor first purchases additional shares of a stock that he or she currently owns and then sells the stock at a loss within 30 days of the purchase? Unfortunately, the wash sale rules (the wash sale rule prevents you from claiming a loss on a sale of stock if you buy replacement stock within the 30 days before or after the sale) still apply. The prohibited period for wash sale rules is better described as 61 days — the day of sale and the 30 days before and after.

Can an investor avoid the wash sale rules by selling a security from her taxable account, and directing her IRA to purchase the same security? Most tax advisors have advised against this strategy even though mainstream financial news outlets were touting this as a viable option during 2008. Revenue Ruling 2008-5 provides a definitive answer and concludes that a purchase by an investor’s IRA is equivalent to a purchase directly by the investor for purposes of the wash sale rules. Furthermore, the loss disallowed because of the wash sale rules will not add to the basis of the IRA and is therefore lost forever. The same reasoning should apply to other entities over which the investor has complete control, such as corporations or trusts.

The wash sales rules apply to a purchase of the same security or a “substantially identical” security within the 61-day period. Exxon is not “substantially identical” to Chevron; however, is a Vanguard S&P 500 index fund “substantially identical” to a Fidelity S&P 500 index fund? The rules are unclear on this point. IRS Publication No. 564 says that “ordinarily” shares issued by one mutual fund are not substantially identical to shares issued by another mutual fund, but investors should be cautious. The IRS could argue that swapping funds that track the same index does not change the investor’s economic situation, and the IRS may disallow the loss.

Converting an Existing Traditional IRA to a Roth

One silver lining in the stock market freefall is that converting a traditional IRA to a Roth IRA just got much cheaper. For some taxpayers, the cumulative deductions from contributions to their traditional IRA might even exceed the income recognized at conversion. Conversions in 2008 are only allowed for taxpayers with an adjusted gross income (AGI) of $100,000 or less, before taking into account the income recognized at conversion. Taxpayers who would convert in 2008 except for the AGI test will get their chance beginning in 2010. For tax years beginning after 2009, the AGI limits disappear.

Any individual who converted their IRAs to a Roth during 2008 should consider undoing the transaction if the Roth has suffered a significant decline since conversion. Assume that a taxpayer’s deductible IRA was worth $100,000 January 31, 2008 when it was converted to a Roth. If the Roth IRA remained invested in stocks and fell to $60,000 by the end of 2008, ordinary income tax will be owed on $40,000 of losses. To mitigate this result, taxpayers can undo the original conversion by transferring the Roth IRA back to a traditional IRA. The deadline for this transaction is October, 15, 2009.

In many cases, the taxpayer will want to again convert the traditional IRA to a Roth, but at the lower value. The required waiting period for this transaction is the later of 30 days after the transfer of the Roth back to a traditional IRA or the first day of the year following the year in which the original conversion to a Roth occurred. If the original conversion to a Roth occurred during 2008, the re-conversion to a Roth cannot occur before January 1, 2009. These rules effectively limit conversions to a Roth to once per calendar year. The rules for converting back to a Roth IRA are the same as an original conversion, meaning in this case that the $100,000 AGI test is applied to 2009 income.

Note for 2010: For 2010 and later, the more restrictive AGI limits for contributing to Roth IRAs versus traditional IRAs effectively disappear. Taxpayers can simply make the maximum allowable contribution to their traditional IRA and then make an annual election to convert their traditional IRA to a Roth.

AMT Relief for ISOs

Significant new relief has arrived for some investors in technology stocks. Some taxpayers who exercised incentive stock options (ISO) created large AMT liabilities that they could not pay because of drastic declines in the value of the underlying stocks, or were left with large unused minimum tax credits (MTCs) that might never be fully utilized. A provision in the Emergency Economic Stabilization Act provided extensive relief to these taxpayers. First, any remaining liability (taxes as well as related penalties and interest) related to the AMT adjustment for the exercise of ISOs in years prior to 2007 was simply eliminated. Second, taxpayers who paid the AMT and are carrying forward long term (pre-2005) unused MTCs due to ISOs or other deferral adjustments can claim those remaining credits on 2008 and 2009 returns as a refundable credit. The amount eligible for this refundable credit is 50 percent of the remaining MTCs, without regard to AMTI or taxable income. If the MTC arose as a result of ISOs and the taxpayer incurred penalties and/or interest for late payment of the AMT liability, the MTC is increased by the amount of interest and/or penalty associated with the late payment.

So whether your clients decide to be greedy or fearful, the above opportunities give you ample ammunition on how to advise your clients wisely.

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LeAnn Luna is an assistant professor and holds a dual appointment with the Department of Accounting and Information Management and the Center for Business and Economic Research, both at The University of Tennessee.