Additional reporting from Emma Rapaport, editorial manager, Morningstar Australia.

2020 saw enormous stock market gains. High-profile fast movers – like Tesla (TSLA), Apple (AAPL), Amazon (AMZN) and Zoom (ZM) – blazed seemingly unstoppable (though volatile) upwards growth paths. And thanks to stock-market apps and online trading platforms offering friction-free access to everything the market has to offer, everyone could (and did) participate. Ordinary investors with no special training or knowledge entered the market with modest means and exited with newfound wealth.

That is, until the taxman came calling. Now, with 2020 tax season upon US investors, some of the unintended consequences for last year’s new DIY investors are becoming apparent.

On March 22, Arizona-based financial planner Brian Wruk of Transition Financial Advisors Group, Inc. got an “urgent text” from a newbie investor who, completing his 2020 tax return, was faced with a tax bill he said was $800k, although he’d only earned $60k at his day job.

DIY done wrong

Age 30 and working full-time as an insurance agent, the worried investor – who we’ll call Derek – opened a brokerage account early in 2020 with $30k in cash, which his brokerage allowed him to triple through margin for a total of $90k available for day trading. Then, throughout the year, he completed between ten and 50 trades per day, with roughly $200k to $2 million in trading volume, three to four days per week.

As Wruk explains, “In 2020, Derek transacted $45M – yes, million – in total trades for a net profit of $45k at the end of the year – or so he thought. Instead, when he input his Form 1099-B (a US federal tax form recording gains and losses during a tax year) into tax filing software, he had $1.4M in capital gain income and a tax bill of just over $800k.”

A tax rule hiding in plain sight

Derek’s taxable capital gains result from the “wash sale” rule, an IRS regulation prohibiting an investor from claiming a loss by selling and purchasing the same or similar securities without a 30-day holding period. The wash-sale rule provides that if an investor wants to sell a security at a loss, then buy the same or a “substantially identical” security within 30 calendar days either before or after the sale, the wash-sale rule will kick in and no loss will be claimable for that security on the current-year tax return.

Derek’s lack of knowledge of the wash-sale rule is where he went astray: “This poor soul traded all of the popular stocks you see in the media consistently all year long,” says Wruk, “and per US tax rules, Derek booked a profit – but was disallowed all the losses because he never once waited the 30 days on those stocks to book the loss.

Wall Street Bets

In Australia, a version of the 'wash sale' rule is in effect. Investors who have incurred large capital losses on shares can use them to offset capital gains they have realised. Any unused losses can be carried forward to offset capital gains in future years. But there are limitations.

As Danny Mazevski, principal chartered tax and financial adviser with AMCO Public Accountants explains, around the time of the Global Financial Crisis (and subsequent recovery), the ATO issued public ruling TR 2008/1. This rule stopped investors from crystalising losses where the primary purpose of the transaction was to derive a tax benefit - the 'wash sale' rule.

"What may appear appears on the surface to be a very tax effective strategy to sell underperforming assets and re acquire same is ill advised," he says. 

"The thought process here is to crystalise a tax loss (capital or operating) and offset (‘wash’) the gain made on the other investments (be it in the same asset class or different asset classes). 

"The clear message from the ruling and Sect 177 of the Act, is that where a transaction is entered where the dominant purpose is to access a tax benefit, the Act provides the Commissioner with powers to cancel the transaction and make a compensating adjustment."

Brett Evans, managing director, Atlas Wealth Management provides a clear example of this rule in action:

"If you were unlucky enough to own a lot of Telstra shares, and were to sell some or all of your holdings down due to the company’s underperformance and in turn created a taxable loss, then this wouldn’t be classified as a wash sale," he explained to Morningstar contributor Nicki Bourliufas.

"However, if you were to sell these Telstra shares and then repurchase the same or similar amount back in a short period of time, then it can be argued that the reason for the sale was not because you wanted to reduce your position in Telstra, but to crystallise a capital loss – otherwise you wouldn’t have re-entered the position." 

MORE ON THIS TOPIC: Avoid this expensive tax-time mistake

Mazevski says the Commissioner's concern and focus is on transactions that "are structured with complexity, are artificial/contrived and can only be explained by reference to the tax benefit obtained."

Robinhood

"In addition, the manner in which the transaction was entered is not consistent with a way a normal investor holds and realises investments," he says. "I.e investors will not normally sell and immediately reacquire same or substantially the same shares in a company (self-cancelling arrangements.)"

While Mazevski was unable to comment Derek’s case (without access to detailed records), he urges investors to be careful. "If you're selling to crystalise losses, take advise - and not just at tax time but progressively through the year. Professional tax advice is more important than ever given that some of these transactions are quite significant and financial exposure/risk of non-compliance is very high."

Remember the taxman

James Gerrard, a director of financial planning firm financialadvisor.com, says he hasn't seen such an extreme example walk through his door as Derek. However, he is seeing general confusion around capital gains tax implications, particularly as markets come down off their February 2021 peak.

"We've seen two different circumstances pop up recently," he says.

"First first time investors who bought in the big market sell off last year are now seeking to realise their gains. They want to take what they gained before they lose it. For example, we have clients who bought oil stocks between March and June that are now up 60 per cent to 80 per cent in value. But many of them haven't taken capital gains implications in account. Because they haven't their shares for more than 12 months, they're not eligible for the 50 per cent capital gains tax discount."

"We're also seeing investors who purchased cryptocurrency over the last year fail to realise that they have to declare and pay capital gains on their gains. They think that because crypto is not really like a share or a currency like the AUD or USD that they don't need to declare it tax return. But crypto trading platforms are sending data to the tax office and and capital gains tax will apply."

How do DIY investors avoid a fate like Derek’s?

If you want to get started day-trading stocks, you might think all there is to do is pick a trading platform and then pick the stocks you want to trade. But Derek’s story shows the pitfalls of proceeding without professional advice.

Just as important as choosing your trading strategy is the need to understand the likely consequences – including tax implications – of your transactions. “Derek’s case demonstrates the difference between tax planning and tax preparation,” comments Wruk.

“Tax preparation is a purely historical event, while tax planning can help you avoid the kind of ‘oops’ moment that Derek is now facing.”