Optimal Portfolio Choice with Wash Sale Constraints

Abstract

We analytically solve the portfolio choice problem in the presence of wash sale constraints in a two-period model. Wash sale constraints induce a trade-off between realizing losses immediately in order to benefit from tax rebate payments and the ability to choose a portfolio composition in accordance with the investor's risk-return preferences. Our results show that wash sale constraints can cause investors to deviate substantially from this latter portfolio. In particular we find that the optimal portfolio composition changes significantly in the presence of unrealized losses. This trading behaviour is to a large extent driven by the desire to realize those losses either immediately by sharply decreasing the holding of assets carrying unrealized losses or indirectly by increasing such holdings in the first period in order to prepare for a decrease in the next period to earn the tax rebate payment.

It is often argued that wash sale constraints can easily be circumvented by trading in correlated assets. We demonstrate that even for rather high levels of correlation, wash sale rules do have an impact on the optimal portfolio composition as investors seek to maintain their portfolio diversified. In all cases the trade-off between realizing losses immediately and the effect of risk preferences on portfolio choice is the driving force.

Our contribution is threefold. First, we show that the presence of wash sale constraints can heavily affect the investor's portfolio choice. Second, we show that in the presence of wash sale constraints optimal portfolio policies may be discontinuous due to the inherent non-concavity of the expected utility maximization problem. Third, based on our analytical solution, we are able to show that the optimal portfolio composition is not necessarily uniquely determined for a wash sale constrained investor. To the best of our knowledge, we are the first to address these problems.

Keywords: wash sale restrictions, asset allocation, portfolio choice, capital gains taxation

JEL Classification: G11, H24