Accounting

How ETFs circumvent IRS wash-sale rules

Published

3 days ago

December 31, 2024

Institutional investors are harvesting ETF losses for tax purposes, then placing their assets in highly correlated funds — regardless of so-called wash-sale restrictions, a new study found.

In theory, IRS guidelines prohibit investors from buying “substantially identical” securities 30 days before or after selling them.

In practice, fund managers, pensions, insurance firms, endowments and other institutional investors “engage in substantial swapping” of ETFs with holdings that are 99% or more the same thing to the tune of $417 billion in assets since 2001 and $106 billion in 2022 in transactions that “seem to lack economic substance beyond harvesting capital losses,” according to a working academic paper released this summer and revised last month by four professors of business and management. The findings, which echo those of another working paper from earlier this year, shed more light on how ETFs help financial advisors and their clients offset the taxes on capital gains by booking losses in their portfolios.

“While the economic intent of the wash sale rule is straightforward, significant uncertainty remains as to the permissibility of tax deductions achieved through ETF swaps,” the report’s authors — Michael Dambra of the University of Buffalo and Andrew Glover, Charles M.C. Lee and Phillip Quinn of the University of Washington — wrote in the introduction. “Specifically, the IRS has not ruled on what constitutes a ‘substantially identical’ security, leaving financial advisors to navigate a foggy legal landscape. Some advisors seem to take the regulatory silence as tacit permission to swap ETFs that hold identical securities or that are even benchmarked to the same index (e.g., Lasser 2011). Others argue that if an investor’s economic position has not changed after swapping ETFs, the spirit of the wash sale rule has likely been violated (e.g., Fischer 2010). Against this backdrop of legal uncertainty, the extent to which investors engage in tax avoidance through ETF wash sales remains largely unknown.”

Representatives for the SEC declined to comment on the report’s conclusions and referred questions to the IRS, which didn’t provide a response.

The findings essentially “confirmed what all of us expected,” but “what was striking about the study was being able to demonstrate that the loss harvesting was material enough to be measured,” said Steve Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center, a nonpartisan think tank.

Tax strategies around possible wash sales have been “going on for decades and decades and decades,” he noted. The rise of ETFs — which topped $10 trillion in assets for the first time in September in a shift fueled by technology, lower fees and tax advantages — has altered the picture. But it’s not clear whether IRS policymakers or members of Congress will try to rein in the wash-sale practices documented in the report.

“I don’t think they view this as high on their agenda, because there’s other tax evasion that goes on. This is lawful, and the question is whether it’s pushing the limits,” Rosenthal said in an interview. “It’s just easier now. There are more vehicles, there are more opportunities, there is more technology to help plan and there are more people marketing these strategies as a result of the ease.”

The study hasn’t been published by a peer-reviewed journal, and the researchers listed some possible “sources of noise” in the data they tracked from quarterly SEC filings of firms’ holdings known as Form 13F and granular trading records from financial technology firm AbelNoser Solutions, a Trading Technologies company. Some swap trades of correlated ETFs could have occurred at random, between the quarterly filings, at lower than 99% matches in their holdings or at an even greater volume when considering the growth of ETFs, the authors wrote.

“Exchange-traded funds provide an efficient way for investors to circumvent the trading frictions associated with the wash sale rule,” Dambra and the other academics wrote. “Specifically, investors can sell a depreciated ETF security and realize a capital loss while simultaneously purchasing another ‘nearly identical’ ETF security. This form of swap trading allows investors to maintain a substantively identical economic position while harvesting a capital loss that can be used to offset realized gains and other taxable income. With an explosion in available ETFs over the past two decades, these securities have become ideal vehicles for circumventing the wash sale rule.”

Their research suggests that ETFs can offer even greater tax efficiency than many experts have pointed out in the past — or that the IRS may be ignoring the enforcement of a rule that has restricted loss harvesting maneuvers for more than a century.

“The expansion of ETFs has provided investors with a new, low-cost tool whereby capital losses can be realized without disturbing an optimal portfolio,” the authors wrote. “Similar to the findings in Li (2024), we find the introduction of a near-identical ETF leads to more volume activity for the incumbent ETF. Next, we find that tax-sensitive institutions hold a more diverse set of highly correlated ETFs, invest a larger portion of their AUM in these ETFs, engage in more swapping between near-identical ETFs and capture more capital losses with this swapping activity. We estimate conservatively that capital loss recognition attributable to annual swapping among tax-sensitive institutional investors is in the tens of billions of dollars. While this behavior is becoming increasingly widespread and economically important, regulators have remained silent on where ETFs fit in their definition of ‘substantially identical securities.’ We contribute to the policy discussion on the potential costs of that continued silence.”

Accounting

FASB seeks feedback on standard-setting agenda

Published

1 hour ago

January 3, 2025

Business Finance News

The Financial Accounting Standards Board today asked stakeholders for feedback on its future standard-setting agenda.

The FASB published an Invitation to Comment and is requesting feedback on improvements to financial accounting and reporting needed to give investors more and better information that informs their capital allocation decision-making, reduce cost and complexity, and maintain and improve the FASB accounting standards codification.

Stakeholders should review and submit feedback by June 30.

Patrick Dorsman/Financial Accounting Foundation

“As a result of the significant progress on the 2021 agenda consultation priorities, the FASB staff is once again seeking stakeholder input on the Board’s future agenda and initiatives,” FASB technical director Jackson Day said in a statement. “We encourage stakeholders to take this opportunity to review the ITC and share their views on financial accounting and reporting priorities they think the Board should address going forward.”

The FASB began the current agenda consultation in 2024, doing outreach to over 200 stakeholders, including investors, practitioners, preparers and academics. The discussion in this ITC is based on input received from those stakeholders and does not contain FASB views. Most of those stakeholders said “there is not a case to make major changes to generally accepted accounting principles at this time,” according to the announcement, so many of the topics that were suggested focus on targeted improvements to GAAP.

The board encourages stakeholders to continue to submit agenda requests about needed improvements to GAAP as they arise.

Accounting

Will auditors embrace AI or fall behind?

Published

3 hours ago

January 3, 2025

Business Finance News

The traditionally static field of auditing is on the edge of an industry-changing transformation, thanks to AI.

As pattern-learning AI machines quickly incorporate themselves into industry after industry, auditing is next in line. Industry giants like the Big Four and Wolters Kluwer are already using AI in their reporting functions. According to a Thomson Reuters Institute 2024 survey of audit professionals, 74% of firms are considering adding progressive technologies like generative AI to their auditing workflows.

As more firms and companies adopt AI in their accounting processes, it signals a significant step toward a new era in which intelligence technology can take over tasks that are too time-consuming and repetitive, allowing for more complex tasks from human counterparts.

Rather than resisting, the industry should welcome this evolution. AI is not a replacement but a partner, enhancing the value auditors bring by handling routine tasks with precision, allowing professionals to focus on areas where human judgment and creativity are irreplaceable.

Where AI fits into the current state of auditing

The average auditor typically spends their days conducting data analysis, monitoring for fraud, reviewing accounts, gauging risks and financially planning accounts. However, firms are struggling to keep their employment up, snowballing into less accurate data reporting.

According to Forbes, in 2023, 720 companies cited insufficient staff in accounting and other related departments as a reason for data errors being up more than in previous years.

Even as roles in finance continue to rank among the top earners in the job market, less and less qualified professionals are interested in taking on all of the tasks this career entails. This leaves high-level and top-paid professionals juggling repetitive tasks, day in and day out, eating up time that could be utilized in better ways. It’s no surprise that the main conversation around careers in finance is centered upon work-life balance or the lack thereof. As workplace demands continue to rise, so do simple data-error mistakes.

When incorporating AI into the auditing process, we’re able to better predict security anomalies and solve the answers to repetitive, time-sensitive data needs. For example, instead of waiting until the end of each month for irregularities, AI systems can provide real-time updates.

New workplace dynamics

Auditors are no longer confined to static reports; they now have the power to leverage AI for real-time analyses, instant anomaly detection and precise financial risk forecasting — capabilities that are revolutionizing the field today. By automating routine tasks, AI empowers auditors to dedicate their expertise to high-value areas like complex financial planning and strategic advisory, where human insight remains indispensable.

Moreover, advances in technology are reshaping how auditors interact with financial data. Instead of relying on accountants as intermediaries, auditors can now engage directly with a company’s data through intuitive, AI-powered interfaces similar to chat support. These systems enable auditors to ask questions and receive immediate, precise answers, streamlining workflows and enhancing their ability to deliver timely, actionable insights.

By automating repetitive processes, firms can allocate more resources to addressing complex challenges that demand advanced analysis and strategic thinking. This shift enhances the depth and accuracy of client engagements, enabling faster, more insightful feedback and stronger client relationships. Additionally, these innovations drive higher standards of service delivery, positioning firms as forward-thinking leaders in the field.

The skills needed to keep up

While AI’s ability to automate routine tasks allows professionals to concentrate on more strategic, high-level responsibilities, it also introduces new challenges that must be addressed. As technology continues to evolve, navigating these obstacles will be key to ensuring long-term success and innovation in the industry.

Organizations urgently need to prioritize upskilling their workforce, with 23% of finance professionals highlighting the lack of training in critical infrastructure. Without addressing this gap, even the most innovative technologies risk underutilization, hindering the industry’s progress toward a secure and data-driven future.

Additionally, the finance industry must focus on strengthening data security measures and upholding ethical standards in the use of AI systems. If these areas are ignored, the industry risks eroding trust, facing heightened vulnerabilities and compromising long-term innovation.

Despite these hurdles, the move toward AI-driven workflows signals the dawn of a new era, where collaboration between advanced technology and human expertise drives innovation and redefines the value of financial professionals in a rapidly changing landscape.

Embracing the impact

AI could be coming for the audit industry, not as a threat, but as the greatest asset of this new era. The value of adding AI to the audit process goes beyond efficiency, but solves a bigger industry problem as a whole.

If institutions want to stay ahead, the answer to their problems is right in front of our faces, and slowly being incorporated into the workflows of industries across the landscape every day. We shouldn’t run from this innovation, but instead embrace it and prepare our workforce for the skills needed to thrive in this new world.

As we embrace innovation and AI, our employers and customers will thank us.