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This article is for general education. Not advice. Not a recommendation to buy or sell any security or adopt any investment strategy. Consult an adviser about your specific circumstances.
Anyone who regularly tax-loss harvests has encountered the wash sale rule
If you sell a security at a loss and buy the same security (or a “substantially identical” one) 30 days before or after execution (a 61-day window), your loss gets deferred.
But if you tax-loss harvest ETFs or mutual funds, there’s a lesser-known rule buried in Section 852(b)(4) of the IRC that could trip you up. This rule could cause realized losses to be recharacterized from short-term to long-term, or even permanently disallowed.
The 6-month rule for ETFs
Here’s how the rule works:
If you sell shares of a fund at a loss after holding it for six months or less, you need to check if the fund distributed long-term capital gains on those shares.
If it did, your loss is recharacterized as a long-term loss to the extent of the capital gain distribution.
This example from IRS Publication 550 makes it clear:
April 3rd - You buy a share of fund XYZ for $20.
June 17th - XYZ pays a $2 long term capital gain distribution.
July 15th - You sell your share for $17.5, realizing a $2.5 loss.
Since you held the share for 6 months or less, and the fund distributed $2 of long-term gains on the share, $2 of your $2.5 loss is recharacterized as a long-term loss. The remaining $0.5 is still a short-term loss.
If you’re tax-loss harvesting to reduce other short-term gains in your portfolio, the 6- month rule could ruin that.
Instead of reducing short-term gains, the character matching rules will ensure that the $2 long-term loss reduces long-term gains first. You’ll offset the long-term gains that the fund distributed, but you’ll be left with your costlier short-term gains (see the following diagram for all the details).
The 6-month rule for municipal bond funds
There’s an even more punishing clause of the 6-month rule for municipal income funds.
If you sell the fund at a loss after holding for 6 months or less, your loss is reduced to the extent of any municipal income distributions. That reduction is permanent; the loss is simply disallowed.
Again, an example from IRS Publication 550:
January 10th - You buy a share of XYZ municipal income fund for $40.
February 7th - XYZ pays a $5 tax-exempt distribution.
February 14th - You sell your share for $34, realizing a $6 loss.
Since you held the share for 6 months or less, and the fund distributed $5 of municipal income on the share, $5 of your $6 loss is completely disallowed. You’re left with a $1 short-term capital loss.
Keep in mind, municipal bond funds generally pay income monthly. That means that you could sell a muni fund at a loss after five and a half months, and the loss will be reduced by the cumulative total of all the distributions you were paid.
Oh no, will my qualified dividends become taxable at income rates?
The 6-month rule only applies to capital gains and tax-exempt income distributions. Section 852 makes no mention of qualified dividend distributions.
However, Pub 550 calls out that losses on stock that paid “extraordinary dividends”1 will generally be treated as a long-term capital loss to the extent of the dividends, regardless of holding period. 🫠
Why does the 6-month rule exist?
The 6-month rule almost certainly has its origins in something called “buying a dividend”.
Buying a dividend is something that many ETF issuers warn against in their prospectus.
It’s when you purchase shares of a fund immediately before the ex-distribution date. The distribution you receive a couple of days later is taxable, even though from your standpoint, it’s essentially a return of capital.
Not very tax-efficient.
But buying a dividend can also lead to a tax-character arbitrage, as follows:
Taxpayer A has $100 of short-term capital gains this year.
A finds a fund that’s about to make a huge end-of-year long-term capital gain distribution equal to 25% of its NAV.
A buys a share of this fund for $400 the day before it goes ex-distribution.
He sells the share the next day for $300, incurring a $100 short-term capital loss, while at the same time receiving a $100 long-term gain distribution.
Capital gains and losses are matched first according to their holding period. A’s $100 short-term capital loss is matched against his $100 of short-term capital gains.
He’s left with $100 of long-term capital gains from the fund’s distribution, which are taxed at a preferential rate.
Congress has thought of this!
Since A didn’t hold the fund for 6 months or less, what actually happens is:
His $100 short-term loss becomes a long-term loss.
It’s matched against his $100 long-term capital gain distribution.
He’s left with the same $100 of short-term capital gains that he started with.
Of course, without the 6-month rule, there’d be an even more lucrative tax arbitrage for municipal income funds. Instead of using the distributions to essentially convert short-term gains to long-term gains, you could have converted taxable gains to tax-free income! The IRS shuts down that tax arbitrage with the 6-month rule.
Why isn’t anyone talking about this?
One of the strangest things about the 6-month rule is that nobody seems to be talking about it.
If you scroll through Google search results for “tax loss harvesting etfs,” you get page after page of warnings against wash sales, but no mention of the 6-month rule (including in this Investopedia article titled A Complete Guide to Tax-Loss Harvesting With ETFs, this Betterment article on their ETF loss harvesting methodology, and this Vanguard article on tax loss harvesting).
It should be spoken about more; advisors should ask their vendors how they’re factoring in the 6-month rule into harvesting decisions.
Many vendors market tax-loss harvesting capabilities for ETF portfolios, which end-clients often add funds to throughout the year. After year-end distributions (or year-round for muni funds), this could mean running directly up against the 6-month rule, and having losses recharacterized or disallowed.
If a vendor charges haphazardly into the 6-month rule, there’s a chance they are overstating tax alpha delivered to a client.
Behind the scenes
This is the first draft meme header for this blog post.
My intent was to connect the new concept (the ETF 6-month rule) to something familiar (the wash sale rule).
To suggest they are related, I borrowed from the famous, campy, foreshadowed subtle nod in the closing scene in The Dark Knight Rises (2012).
But I scrapped it because I didn’t think it was funny or clear enough to lead the blog.
It’s a funny scene, but how is it relevant here?
I almost led with this second riff…
But ultimately decided on the Office Space riff because the shock from the doorknob is surprising, just as the ETF 6-month rule (which also applies to mutual funds) might be to someone hearing of the rule for the first time.
Have a great Sunday
“extraordinary dividends”
Loss on stock that paid qualified dividends. Any loss on the sale or trade of stock must be treated as a long-term capital loss to the extent you received, from that stock, qualified dividends (defined in chapter 1) that are extraordinary dividends. This is true regardless of how long you actually held the stock. Generally, an extraordinary dividend is a dividend that equals or exceeds 10% (5% in the case of preferred stock) of your adjusted basis in the stock.
See IRC §1(h)(11)(D) which refers to IRC §1059(c).
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Thanks for bringing attention to these obscure, but important rules for TLH.
There's an exception to the 6-month exempt-interest dividend rule, such that it doesn't apply for funds that accrue dividends daily. Most Vanguard mutual funds (but not ETFs) fall into this category, so I'm more comfortable using them for TLH.
There's some more details on the bogleheads wiki: https://www.bogleheads.org/wiki/Tax_loss_harvesting#Fine_points_about_tax_loss_harvesting
Great explanation!