How investors are trading to minimize taxes

By Alexandra Richter

BUFFALO, N.Y. — Investors are capitalizing on a loophole in U.S. tax laws that has led to billions of dollars of lost tax revenue, according to new research from the University at Buffalo School of Management.

The study finds that investors are selling and repurchasing nearly identical exchange-traded funds (ETFs), a group of stocks, bonds or other securities, as a strategy to minimize taxes owed to the federal government and bypass long-standing tax laws.

“Our study examines how investors are swapping shares of similar EFTs to claim a tax deduction for investment losses while maintaining essentially the same holdings in their stock portfolio,” says study co-author Michael Dambra, PhD, associate professor and Kenneth W. Colwell Chair of Accounting and Law in the UB School of Management. “While tax laws prohibit claiming a tax loss if an investor sells and repurchases a substantially identical investment within 30 days, the Internal Revenue Service has remained silent on where ETFs fit in this definition.”

To investigate the extent and impact of ETF trading activity and tax loss generation, the researchers analyzed more than two decades of data from 2001-2022 from the CRSP Mutual Fund Database, Abel Noser database, WhaleWisdom 13F filings and SEC filings.

The study reveals this tax-motivated trading behavior is concentrated among investors who have to pay taxes on investment gains. By purchasing and quickly trading similar ETFs, investors are achieving substantial tax benefits. Since 2001, the authors estimate that approximately $417 billion of nearly identical ETFs have been swapped by investors, with $106 billion in 2022 alone. The authors then find investors who engage in ETF swaps recognize more tax losses.

“Our findings emphasize the need for clearer regulations from the IRS,” says Dambra. “Currently, financial advisors are navigating a foggy legal landscape, with some advisors taking regulatory silence as tacit permission to swap ETFs that hold identical securities, while others argue that if an investor’s economic position has not changed, the spirit of the tax law has been violated.”

As this investment strategy becomes increasingly widespread, the economic impact of this investor practice and the IRS’ silence increases at the expense of lost tax revenue, according to the researchers.

Dambra collaborated on the study with Andrew Glover, PhD student, University of Washington Foster School of Business; Charles M.C. Lee, PhD, professor of accounting and Kermit O. Hanson Professor in Accounting, University of Washington Foster School of Business and Phillip J. Quinn, PhD, associate professor of accounting and PricewaterhouseCoopers Professor, University of Washington Foster School of Business.