How smart investors use ETFs to legally bypass IRS wash sale rules

How smart investors use ETFs to legally bypass IRS wash sale rules

Roger Wohlner

Mon, August 10, 2026 at 6:17 PM GMT+3 4 min read

Tax loss harvesting is a very effective strategy for investors to trim their tax bill each year. Selling underperforming holdings in a taxable account for a loss can help offset gains realized elsewhere. You can use losses to offset realized capital gains and can use up to $3,000 of capital losses to offset other income each year.

One potential roadblock, though, is the IRS wash sale rule (IRS section 1091).

What is the wash sale rule?

The wash sale rule disallows the loss if you purchase the same or a "substantially identical" security within a 61-day window (30 days before the sale, the day of the sale, and 30 days after the sale). This is to prevent investors from "gaming the system" by selling a holding for a loss, taking the tax write-off and immediately rebuying the identical security at a lower price.

The wash sale rule applies in many cases that investors might not consider, including:

• Purchasing the same or a substantially identical security in a spouse's account within the prohibited time frame is a violation.

• Purchasing the same or a substantially identical security in a tax-deferred account like an IRA is a violation.

• A new calendar year does not impact the 61 day timeline.

This can create a serious dilemma for some investors: Sell the security for a tax loss, but then potentially miss a rebound in the price of the security during the 30 days following the sale.

Related: Vanguard renames key funds to highlight Morningstar benchmarks

What does "substantially identical" mean?

The concept of substantially identical is a key one, and one that can be vague. If you were to sell shares of Intuit stock at a loss then immediately rebuy shares in Intuit, that is pretty clear. Likewise if you were to sell and then rebuy shares of the Vanguard S&P 500 ETF (ticker VOO).

Where it can get vague is if you sold shares of VOO at a loss and then bought shares of another ETF or mutual fund that tracks the same index.

ETFs can aid in tax loss harvesting, which can ultimately help investors reduce their taxes.

How can ETFs help you avoid violating the wash sale rule?

ETFs can offer a viable strategy for investors looking to avoid the wash sale rule in several ways.

Selling an individual stock and buying an ETF in the same sector

Let's say an investor sells shares of Pfizer stock (ticker PFE) at a loss. Instead of purchasing shares of Pfizer and invoking the wash sale rule, they could buy shares of an ETF that tracks the healthcare sector such as the Vanguard Healthcare Index Fund ETF Shares (ticker VHT). This allows you to lock in the tax loss and related tax deduction while staying invested in the healthcare sector. A diversified ETF is not considered substantially identical to shares of an individual stock.

Selling a benchmark index fund and buying a different index ETF

This scenario would involve selling an index mutual fund or ETF at a loss and immediately buying shares of an ETF tracking a different index but with similar holdings and performance characteristics. An example might be selling shares of the State Street® SPDR® S&P 500® ETF Trust (ticker SPY) at a loss and purchasing shares of the Vanguard Morningstar Total Stock Market ETF (ticker VTI).

VTI tracks a different index and is a bit broader in scope than the S&P, but the two funds share many holdings and have many similar performance characteristics.

Sell an active mutual fund and purchase a passive ETF

Another scenario might involve an investor selling an actively managed mutual fund at a loss and then buying shares of a passive ETF in the same asset class. For example, if an investor sold shares of The Growth Fund of America (ticker AGTHX), an actively managed large cap growth fund at a loss, and then purchased shares of the Vanguard Morningstar Growth ETF (ticker VUG) a passive large cap growth ETF, this would allow them to realize the loss on AGTHX while remaining invested in an ETF that is also in the large cap growth asset class.

Two critical pitfalls to avoid

While these ETF strategies are legal and widely used by institutional wealth managers, individual investors can easily get tripped up over subtle landmines:

Dividend Reinvestments (DRIP): Dividend Reinvestment Plans (DRIPs) inside the 61-day window can trigger a partial wash sale automatically if a dividend reinvests into the security you recently sold for a loss. Be sure to turn off auto-reinvestments on tax-harvested positions.

Cross–account activity: The wash sale rules apply across all accounts you and your spouse own. If you sell an ETF, mutual fund, or other security at a loss in a taxable individual account and purchase the same security in your IRA or 401(k) within 30 days, the loss is permanently disallowed.

Related: Popular ETFs carry hidden tax rules that surprise retail investors

This story was originally published by TheStreet on Aug 10, 2026, where it first appeared in the Investing section. Add TheStreet as a Preferred Source by clicking here.