On May 6, 2010, the Dow Jones Industrial Average was already down more than 300 points at 2:42 PM Eastern time, mostly due to concern about the Greek debt crisis. What happened next is truly bizarre. A series of cascading events, probably set off by a computerized trading algorithm, caused the market to drop another 600 points over the next five minutes. By the time the market closed at 4:00 PM, most of this last drop had been recovered and the market closed for the day down 342 points. Why is a tax newsletter writing about this? Because the precipitous price drop triggered a lot of selling through stop-loss orders.
Suppose you had purchased a stock years ago at $10 per share and when the market opened on May 6, the stock was trading at $100 per share. Aware of your significant unrealized gain in the position, you had a stop-loss order in place to sell the stock if its price dropped to $80 or below. During the chaos that ensued, your stock dropped to $80 and your position was sold. By the end of the day, the price of the stock had rebounded to $100. The so-called “flash crash” not only cost you $20 on the value of the stock when your position was sold, to add insult to injury, it also triggered a tax gain of $70 per share. You lost money and have tax to pay!
The IRS was asked by someone whether it could formulate some kind of policy that would permit taxpayers who quickly re-established positions sold during the flash crash as a result of stop-loss orders to avoid having to report and pay taxes on their gain. In a letter dated September 24, 2010, the IRS explained that there are no provisions in the Internal Revenue Code which permit a taxpayer to not recognize his gains that were triggered during the flash crash. The IRS pointed out that this kind of relief would have to come from Congress.