Forums  > Trading  > The Wash Sale Rule is Decadent and Depraved  
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Total Posts: 401
Joined: Jan 2015
Posted: 2019-10-16 17:49
Public Service Announcement. If you're a US tax-domiciled algo trader, then you need to be aware of the wash sale rule.

Not just in the sense of "make sure you talk to a CPA to do tax planning, so you can shave a few percent off your bill". But literally in the sense that the wash rule can theoretically generate unlimited tax liability for an algo trader. There are scenarios where you can end up owing more than 100% of your income to the IRS. Consider a thought experiment.

Alice runs a high-frequency pairs trading strategy between stock X and stock Y. Each trade averages a profit of 1 bp. X tends to lead Y, so the average per-leg profit is +5 bps for Y and -4 bps for X. The transaction costs run 0.25 bps per leg. Let's say Alice trades $100 billion notional in 2019, for a net profit of $5 million.

Now let's look at tax liability. Once taking into account trade costs, Alice will have $47.5 million realized short-term capital gains income on her trades in Y. And a $42.5 million capital loss on X. However (assuming she continues through January 2020), it's likely that almost all of the latter will be disallowed under wash sale rules. That leaves Alice with a $47.5 million taxable income. And a tax bill around $20 million. On a real income of $5 million...

Let's look at why the capital losses are actually disallowed. The wash sale rule says that every time you exit a position with a loss, you can only deduct the loss if you don't re-enter the position within 30 days. It's a well-intentioned rule designed to prevent something like Softbank harvesting its tax losses on WeWork by selling all its shares on December 31, then buying them back on January 1. However an algo trader that buys and sells a stock for 1 second, then does it anytime within the next month is equally affected. (The common sense reform would be to say the wash sale rule only applies for positions held longer than 30 days, but tax law, much like bird law, is not governed by reason.)

Needless to say, virtually all trading done by high-turnover algo strategies are wash sale eligible. What happens to the tax loss on a wash sale? It gets deducted from the cost basis of the next trade on the same symbol in per-share FIFO order. So won't it stochastically fall out in an algo trading context? Even if Alice on average loses money in X, nearly 50% will be non-wash sales. So most of the wash sale losses will end up harvested, right?

Nope. Wash sale determination is based on the tax accounting basis, not the trade prices. And losses from prior wash sales offset the cost basis on subsequent trades. Once you've accumulated enough wash sale losses, your cost basis becomes sufficiently depressed that every trade is a tax loss, even if it's individually profitable. Think of it as a biased random walk. Say Alice is profitable on 49% of her trades in X. Once her cumulative profits dip low enough, the cost basis offset becomes too large and every single trade, regardless of real profit, becomes a tax/wash loss.

But don't the losses roll off after 30 days? Not if you continue to actively trade the symbol. Say you lose $1 trading X on day 1. You have $1 in washable losses Then on day 30 you break even on a trade in X. However the $1 wash loss offsets the cost basis, so you have another $1 tax loss. Which means that the wash has been laundered into the new trade, and wash-eligibility is re-pegged at day 30. If you trade again on day 60, it refreshes yet again. A wash loss can theoretically be rolled forward forever. The only way to break the chain is to either stop trading the symbol completely for 30 days or make enough profitable trades on the symbol to cancel out your prior cumulative losses.

But won't Alice's tax bill just cancel out next year? First the IRS isn't going to sit on its hands for a year when someone owes $20 million. Second as long as Alice continues to trade the strategy, the wash sales will keep chaining forward. But let's say she does stop trading X for 30 days. What happens is the final non-washed trades will have a super depressed cost basis. So Alice will finally realize her $42.5 million capital loss on X. If that's in the same tax year, then things are fine. She can just cancel out the capital gains on her profitable trades when rolling up her income.

But if it's in the next tax year, then Alice is truly fucked. Individuals and LLCs can't carryback capital losses. So Alice is stuck with $42.5 million in capital loss carryforwards. Even assuming she continues to generate $5 million in annual trading income, it would take nearly a decade to become solvent. And if not, capital loss carryforwards only offset $3000 in ordinary income per year. It would take 14,000 years to become solvent.

Practical takeaways. Tax planning is really boring. And most of the time it's fine to let the CPAs handle it asynchronously, and not pay attention until April 15 rolls around. At worse poor planning usually just means paying 40% instead of 20%. But for algo-traders, it's very important to evaluate wash sale impact before December 31. That's because the only way to make sure that wash sale offsets don't roll over into the next year is to stop trading a symbol completely for 30 days starting from January at the latest.

In particular, pay close attention to any symbol that you primarily use for hedging purposes. Wash sale tsunamis, like Alice's, happen on symbols where cumulative profits are consistently negative. And remember tax accounting incorporate all the costs related to sales (i.e. exchange fees, cancel fees, commissions, pro-rated colocation fees, etc.). Also remember that wash sale logic is extremely bespoke. Don't necessarily count on your broker to get it right. And don't just spot-check or guesstimate it.

If you're preemptive about it, you should also take a Section 475 mark-to-market election. Then the wash sale rule no longer applies. But that has to be already done by the beginning fo the relevant year. I.e. you can't do it retroactively. Also at least as an individual it's predicated on trader tax status, so if the IRS challenges that, then MTM also is in jeopardy.

It's probably not a major issue for you. But remember there's a small corner case of scenarios where the impact of the wash sale rule becomes truly pathological.

Good questions outrank easy answers. -Paul Samuelson


Total Posts: 401
Joined: Jan 2015
Posted: 2019-10-16 19:12
Another unrelated pernicious affect of the wash sale rule is that it has the potential to effectively convert all your unrelated long-term gains into high-tax short-term gains. Like a virus across a tax entity's entire portfolio.

That's because for purposes of determining holding period for long vs. short-term, the period includes all chained wash sales. If the wash chain extends past 365 days, then all those losses are counted as long-term. Meaning if you have any realized long-term gains, they're offset with priority before short-term gains.

Assume that the prior strategy was run inside a much larger multi-strat fund. And say the $42.5 million capital losses on the losing symbol X is washed for over 365 days. When that capital loss is realized it counts as a long-term capital loss, whereas the $47.5 million capital gains in the strategy are counted as short-term. Say the fund had $100 million in long-term capital gains from unrelated strategies. The $42.5 million loss gets deducted from that before the short-term losses from the other leg of the strategy.

In effect the algo-strategy has effectively pumped $42.5 million from the long-term rate to the much higher long-term rate. Since the difference is about 20%, it's increased the fund's total tax liability by $8 million dollars. Which has more than offset the actual income of $5 million generated by the trading strategy.

Good questions outrank easy answers. -Paul Samuelson


Total Posts: 457
Joined: Mar 2005
Posted: 2019-10-17 18:09
This is the learned insight I miss from NP. Good on you, EL. Not my space but I nevertheless enjoyed reading it!

HEY! What about the guy who first landed on the moon? He said "one small step for man". I'd just have said "OMG I'm on the moon!"
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