Analysis of Proxy Index Strategies for Tax Loss Harvesting Compliance

This analysis synthesizes insights from expert sources and investor discussions to evaluate proxy index strategies for tax loss harvesting (TLH). Rotating ETFs tracking distinct but correlated indexes (e.g., S&P500 vs Total Stock Market) is a compliant TLH method, as it avoids the IRS’s “substantially identical” clause [1]. In contrast, swapping same-index ETFs like VOO and SPY—both tracking the S&P500 but from different issuers—poses wash sale risks, despite conflicting investor opinions, due to expert warnings [3,5]. Basket strategies (4-5 non-identical ETFs) enable consistent TLH during corrections by providing multiple rotation options while maintaining market exposure [7,9].

1. IRS Ambiguity Drives Strategy Risks
   : The IRS has not formally defined “substantially identical” securities, leading to conflicting guidance on same-index ETF swaps [4].
2. Basket Strategies Mitigate Uncertainty
   : Portfolios of non-identical ETFs reduce reliance on single swaps, enhancing TLH consistency across market cycles [7].
3. Expert Consensus Favors Different-Index Swaps
   : Wealthfront’s methodology explicitly recommends different-index ETFs to avoid wash sales, a view supported by Kiplinger and NerdWallet [1,3,5].

: Same-index ETF swaps may trigger wash sale disallowance, increasing tax liability [1]. Regulatory ambiguity could lead to IRS audits for non-compliant strategies [5].
: Basket strategies enable investors to harvest losses during corrections, enhancing after-tax returns over time [7]. Different-index ETF swaps offer compliant TLH without sacrificing market exposure [1].

Optimal TLH practices include using different-index ETFs for swaps and adopting basket strategies to maintain consistency. Investors should consult tax professionals to navigate IRS ambiguity, as no official ruling exists on VOO/SPY similarity [4,5]. TLH effectiveness depends on adhering to the 61-day wash sale window and avoiding substantially identical securities [4].