Skip to main content
Open this photo in gallery:

In February, Pro Publica reported that Steve Ballmer, through his trading account at Goldman Sachs, had sold shares in the dual-listed natural resources giants Shell and BHP, then replaced them on the same day with identical amounts of the other class of the companies’ shares, and claimed a chunky deduction.Stephanie Keith/Getty Images

Sign up for the Globe Advisor weekly newsletter for professional financial advisors on our newsletter sign-up page. Get exclusive investment industry news and insights, the week’s top headlines, and what you and your clients need to know.

Goldman Sachs Group Inc. says it aims to provide “best-in-class investment advice to clients, consistent with both the letter and the spirit of all applicable tax laws and regulations.”

So, the bank was quick to say that it would change its trading practices after a media organization claimed it had helped former Microsoft Corp. boss Steve Ballmer subvert at least the spirit of U.S. laws against so-called “wash sales.”

Investors will be familiar with the idea of tax-loss harvesting: selling an underperforming stock to crystallize a loss that can be offset against capital gains elsewhere, to lower your overall tax bill. It’s common practice to prune a few losers before the end of the tax year.

But you can’t simply buy the same stock back and still claim the deduction. It really has to be kicked out of your portfolio.

However, in February, Pro Publica Inc. reported that Mr. Ballmer, through his trading account at Goldman Sachs, had sold shares in the dual-listed natural resources giants Shell PLC RYDAF and BHP Group Ltd. BHPLF, then replaced them on the same day with identical amounts of the other class of the companies’ shares, and claimed a chunky deduction.

Under U.S. law, a wash sale is defined as one in which the investor makes a “substantially identical” purchase within 30 days. Goldman Sachs told the Financial Times it would halt repurchase transactions involving dual-class shares and had alerted clients to the mistake. A spokesperson says the affected trades were very small in number. Mr. Ballmer told Pro Publica that he would amend his tax filings.

But the biggest impact from Pro Publica’s investigation may not be the tweaks to Goldman Sachs clients’ tax filings. It may instead be the spotlight it shines on the explosive growth of tax-loss harvesting strategies. The use of dual-class share replacements was a tiny part of what Goldman’s traders achieved for Mr. Ballmer, who netted an extraordinary US$579-million in tax-loss harvesting over five years, according to Pro Publica’s calculations.

And this is not a billionaires’ only game. Far from it. Tax-loss harvesting has been mechanized thanks to the collapse in trading costs and the rise of so-called direct indexing.

Investors can acquire algorithmically-controlled portfolios of hundreds of stocks that are built to track a broad stock market index but are also programmed to sell lossmaking shares throughout the year to crystallize tax losses and replace them with alternative investments to keep the portfolio on track.

A pioneer of the strategy, Parametric Portfolio Associates LLC, was purchased by Morgan Stanley after a bidding war in 2020. Rival JPMorgan Chase & Co. eventually bought another platform called 55ip, and the two wealth managers have put their tax-loss harvesting products at the centre of a fierce price war. Market research sponsored by Parametric suggests direct indexing could account for US$800-billion in assets by 2026.

Academic studies show the strategy can add 1 to 2 per cent a year in after-tax returns to a diversified equity portfolio, and can even be used to give a boost to fixed-income portfolios.

Marketing materials from the investment manager Northern Trust Corp. (NT) demonstrate how sophisticated the products have become. It says the tax losses can be dialled up or down depending on how much deviation from the underlying index an investor is willing to risk. NT did not respond to a request for comment.

There’s no suggestion any of these platforms engage in illegal wash sales by using substantially identical replacements. That’s the point. They don’t have to. But algorithms can be programmed to go more or less close to the line.

So, it wouldn’t be surprising if authorities were tempted to move the line and toughen the rules. The word “substantially” could be made to do a lot of work.

The Internal Revenue Service (IRS) hasn’t provided much in the way of guidance about what “substantially identical” means in modern markets, with the result that different advisors take more or less conservative positions.

In a piece on the “silver lining” of tax-loss harvesting opportunities in the down market of 2022, Morningstar Inc. warned investors against replacing an exchange-traded fund (ETF) with another that tracked the same index, even if it was run by a different asset manager.

“It’s probably safest to replace fund holdings with a vehicle that tracks a different index,” Morningstar strategist Amy Arnott wrote. “For example, an investor selling Vanguard 500 Index Fund, which tracks the S&P 500, could replace it with Vanguard Total Stock Market Index Fund, which tracks the broader CRSP Total Market Index.”

Tax authorities could also squeeze investors in a variety of other ways that raise the costs or risks of the strategy – by making investment advisors liable for the violations of their clients, or just by subjecting more users of tax-loss harvesting strategies to gruelling audits. The IRS has just had US$80-billion added to its budget and is itching to spend it.

The nuclear option would be for the U.S. Congress to step in. David Schizer, tax professor at Columbia Law School, told Pro Publica that the law should be rewritten to change “substantially identical” to “substantially similar.”

Individual investors obviously don’t want to lose the better after-tax returns they can enjoy thanks to the mechanization of tax-loss harvesting. But if it substantially erodes the tax base, politicians will only be encouraged to find new taxes elsewhere to crimp investors’ returns by other means – like the new U.S. tax on share buybacks, for example. That really would be a wash.

© The Financial Times Limited 2023. All Rights Reserved. FT and Financial Times are trademarks of the Financial Times Ltd. Not to be redistributed, copied, or modified in any way.

For more from Globe Advisor, visit our homepage.

Report an error

Tickers mentioned in this story