Investors who have incurred large capital losses on shares can use those capital losses to offset any capital gains they have realised. Any unused losses can be carried forward to offset capital gains in future years, without a limit on how long they can be carried forward. Though capital losses from shares can't be used to reduce your taxable income, just the capital gains you declare.

The 'wash sale' rule

This describes the quick sale and re-purchase of securities to minimise tax, also known as tax loss harvesting. "The sort of transactions that the ATO is watching closely are those that generate a tax benefit where a benefit would not have ordinarily been available if the transaction wasn’t entered into in the first place," says Brett Evans, managing director, Atlas Wealth Management.

If you are an investor who was unlucky enough to invest in an underperforming stock, selling your position and turning it into a taxable loss would not be classified as a wash sale.

However, if you were to sell those shares, and then repurchase the same, or similar amount back in a short period of time, this may be classified as a wash sale. The argument may be made is that the reason for the sale of the underperforming stock was not because you wanted to reduce your position in Telstra, but to crystallise a capital loss. Reentering the position is strong evidence of this.

According to Bruce Brammall of Bruce Brammall Financial, the ATO can’t stop you from selling or buying assets, but if you are selling shares to crystallise a loss, he urges investors to be careful.

"The ATO wants to make sure that taxpayers aren’t just selling shares just to get a tax break. So, if you sell shares to crystalise a loss, with the aim of using that capital loss to offset a capital gain on other shares, then buy back the same amount of shares on the same day, or within the same week, they might view that as a wash sale," he says.

According to Colin Lewis, head of technical, Fitzpatrick Private Wealth, other situations that may be considered a wash sale include:

where a taxpayer enters into an arrangement to sell and re-purchase an asset at substantially the same price, or just before or at the time of the sale of an asset;

purchasing financial instruments that deliver the same financial benefits that arise from the previous direct ownership.

"The ATO is interested in sell and buy transactions that occur in a short timeframe without defining a specific timeframe. Like many things in tax law, there is no 'statutory' timeframe to avoid a 'wash sale', as it generally comes down to whether or not the dominant purpose of the transaction is designed to derive a tax benefit. If that’s the case, then there’s always a risk and will be open for the ATO to take it to task," says Lewis.

Atlas Wealth Management’s Evans adds: "The most important thing to keep in mind is that the ATO's data matching ability has grown remarkably in the last couple of years. If you haven’t been caught in the past, that doesn't mean you will not be caught in the future. A breach in this regard can result in penalties of up to 50 per cent of the tax avoided," says Evans.

According to Chris Wookey, principal of tax, Deloitte Private, wash sale rules apply to self-managed superannuation funds (SMSF) as much as to individual investors. The ATO will also closely review any transactions, including off-market share sales, which in the past have been used to effect wash sales. These can be contrasted to a situation in which an investor genuinely sells an asset to rebalance their portfolio.

"The ATO has a bit of a natural suspicion about off-market transactions and they suspect that the transactions have been back-dated," says Wookey.

"Although off market transfers are not prohibited, anecdotal evidence indicates that the ATO may suspect backdating of the transfer if it produces a 'convenient' tax outcome. This could lead to time-wasting enquiries and questioning, if the ATO's suspicions were aroused.

"Even if the taxpayer is in the right, they could still end up losing because of the time and cost wasted dealing with the ATO," says Wookey.

The ATO may also review transactions where investors holding shares in their own name sell those shares to a family trust or spouse to create a capital loss, and use this to offset a capital gain. In some instances, this could also be considered a wash sale.

So as always, it pays to get advice when preparing your tax return, and to exercise caution in determining what you claim as a tax deduction and how you assess your capital gains.

More EOFY resources

This webinar with Sharesight CEO Doug Morris focuses in on optimizing tax loss selling opportunities.

 

If you are a Morningstar Investor subscriber (or if you take on a four week, free trial), you are able to model tax loss selling opportunities through your integrated Sharesight subscription. Read more about the unrealized CGT report that can help you calculate how to offset your capital gains.