In April 2026, a tech executive in Austin received a CP2000 notice — the IRS’s “we think you owe more” letter. The issue wasn’t unreported income or a dodgy deduction. It was wash sales: 47 of them, across three brokerage accounts, totaling $83,000 in disallowed losses. The executive had a direct indexing portfolio managed by a well-known fintech platform. The platform harvested losses diligently. It just didn’t track what the executive was doing in his other accounts.
The IRS did. And the IRS’s computers are getting better at this every year.
The enforcement surge
Wash sale enforcement has quietly become one of the IRS’s highest-ROI activities. The agency flagged approximately 2.3 million returns for potential wash sale violations in tax year 2025, according to IRS Statistics of Income data — up from 1.1 million in 2021. The increase isn’t because more taxpayers are cheating. It’s because the IRS can now see what it couldn’t before.
The wash sale rule itself is nearly a century old: if you sell a security at a loss and buy a “substantially identical” security within 30 days before or after, the loss is disallowed. Simple in theory. Nightmarish in practice when an investor holds the same S&P 500 exposure across a 401(k), a taxable brokerage account, a spouse’s IRA, and a direct indexing portfolio — each managed by a different platform that can’t see the others.
The IRS’s matching capability has transformed. The agency’s Information Returns Master File now ingests 1099-B data from every broker, cross-references it against prior-year filings, and runs pattern-matching algorithms specifically designed to detect wash sales across accounts. What was once an honor-system rule is now enforced by database joins.
The revenue impact is significant. The Treasury Inspector General estimated in 2025 that wash sale noncompliance costs the federal government $3-5 billion annually in lost revenue. For an agency under political pressure to close the tax gap without raising rates, automated wash sale enforcement is the closest thing to free money.
Why direct indexing made it worse
Direct indexing — holding individual stocks to replicate an index, enabling granular tax-loss harvesting — has grown from $400 billion in 2020 to over $1 trillion in 2026, according to Cerulli Associates. The pitch is compelling: harvest losses on individual positions while maintaining index-like returns, generating “tax alpha” of 1-2% annually.
But direct indexing multiplies wash sale complexity exponentially. A direct indexing portfolio might hold 300 individual stocks. Each one is a potential wash sale trigger — not just within the portfolio, but against every other account the investor owns. Sell Nvidia at a loss in the direct indexing account while your 401(k)’s S&P 500 fund buys Nvidia the same week? Wash sale. The IRS considers the index fund “substantially identical” to the individual stock for this purpose, though the boundaries remain litigated.
The platforms know this. Most direct indexing providers now ask clients to disclose outside holdings and attempt to coordinate. But disclosure is voluntary, coordination is imperfect, and the IRS doesn’t accept “my robo-advisor didn’t know” as a defense.
Worse, the “substantially identical” standard is expanding. The IRS has signaled — through private letter rulings and audit positions, if not yet formal regulation — that it views different share classes, ADRs vs. ordinary shares, and even highly correlated ETFs as potentially triggering wash sales. The 2026 proposed regulations on the “substantially identical” definition, if finalized, could explicitly cover cryptocurrency and digital assets, closing a loophole that crypto tax-loss harvesters have exploited for years.
The Austin executive’s mistake (and why it’s common)
Back to the Austin executive. His direct indexing platform harvested losses correctly within its own silo. The problem was his 401(k) — managed by a different provider — which automatically rebalanced into the same securities within the 30-day window. Neither platform could see the other. The IRS could see both.
This is the fundamental structural problem: the tax code treats the individual as a single economic unit, but the financial services industry treats each account as a separate silo. The IRS has the unified view. The taxpayer’s advisors do not.
The executive’s $83,000 in disallowed losses didn’t vanish — wash sale disallowed losses are added to the cost basis of the replacement shares, deferring the tax benefit rather than eliminating it. But deferral has real economic cost, especially when the replacement shares are in a tax-advantaged account where the basis step-up is worthless. Losses disallowed against 401(k) purchases are effectively destroyed, not deferred.
The counterargument: is enforcement overreach?
Critics argue the IRS is weaponizing an ambiguous rule against taxpayers who are making good-faith efforts to comply. The “substantially identical” standard, they note, has never been clearly defined by regulation — it rests on decades of case law and administrative guidance that predate modern portfolio construction. Applying it to coordinate across 401(k)s, IRAs, and taxable accounts stretches the rule beyond what Congress intended in 1921.
There is fairness concern here. Wealthy investors with dedicated tax advisors can navigate these complexities. The mass-affluent investors using direct indexing platforms — the exact demographic the IRS is now flagging — often have no idea they’re violating the rule until the CP2000 arrives.
But the counterargument has limits. The wash sale rule exists to prevent taxpayers from manufacturing losses without changing their economic position. An investor who sells Nvidia at a loss and rebuys it three days later in a different account has not meaningfully changed their exposure. The rule’s purpose — preventing artificial loss harvesting — applies regardless of whether the taxpayer intended to violate it.
The honest advice is not that the rule is unfair, but that the coordination problem is solvable. Unified reporting across accounts, which some custodians are beginning to offer, would eliminate most inadvertent violations. Until that infrastructure exists, investors running direct indexing alongside other accounts are playing audit roulette.
What to do now
Three practical steps. First, consolidate where possible — fewer accounts means fewer cross-account wash sale triggers. Second, if you run direct indexing, provide your platform with a complete inventory of outside holdings and update it quarterly. Third, consider turning off automatic dividend reinvestment in taxable accounts holding the same securities as your tax-advantaged accounts — reinvested dividends are a notorious wash sale trigger that most investors never consider.
The IRS flagged 2.3 million returns last year. The number will be higher this year. The agency’s computers don’t get tired, don’t miss patterns, and don’t accept excuses. In the age of automated enforcement, the only safe tax strategy is a coordinated one.
The Austin executive paid his $83,000 — plus interest, plus the accountant’s fee to sort it out. His direct indexing platform is still harvesting losses. It just can’t see the whole picture. Neither, it turns out, could he. But the IRS could.
The category-defining name in tax-managed investing — taxmanagedportfolio.com — is currently available for acquisition by the firm positioned to own this space.
