As Congress recessed until after the November elections, our elected officials left taxable investors with many uncertainties concerning their potential income tax liabilities. The tax cuts passed in 2001 and 2003 are set to expire but Congressional leaders have vowed to return after the election to take up these matters. In the interim they have left taxable investors in limbo trying to plan for future income taxes liabilities without a clear direction of the tax rates on ordinary income, dividends and capital gains.
The general sense is that tax rates are increasing in some fashion. Taxpayers need to start planning for these potential increases, despite their current uncertainty.
One planning technique that should not be forgotten is tax loss selling. During 2008 and early 2009, taxable investors likely saw their unrealized gains from the prior bull market eroded or turned into unrealized and realized losses which potentially created a capital loss carryover. As the market recovered in 2009 and into 2010, taxable investors saw those unrealized gains return and probably started realizing capital gains. Depending on the size of the realized losses in 2008 and early 2009, many of the realized gains have been sheltered into 2010. With the potential of higher capital gains tax rates in 2011, maintaining that capital loss carry forward will become even more valuable. Realizing a loss of $10,000 now could be used to offset a long term capital gain of $10,000 in 2011 with a benefit of $2,000 rather than $1,500.
No investor has a crystal ball on the direction of the market but properly monitoring and managing your realized capital gains can reduce taxes in current and future years. Many call this “Tax Loss Selling or Tax Loss Harvesting.” I like to call this management technique “Capital Gain Management” because it is ongoing monitoring which factors in many variables.
Capital Gain Management
Capital gain management is the selling of securities throughout the year to realize portfolio losses. An investor uses these losses to offset capital gains taxed during the current year or in future years via short and long term loss carry forwards. A loss carry forward is created when there are net losses in excess of the $3,000 net loss allowed on a tax return each year.
Once the investor has sold an investment at a loss, the IRS requires the investor to refrain from buying the same investment or “substantially identical security” for 30 days. This is called the “wash sale-rule”. After 30 days the investor may repurchase the security or a “substantially identical security.” If the investor purchases the security or substantially identical security before 30 days has passed, the losses generated on the original sale are disallowed and the amount of the disallowed loss is added to the cost basis of the new security purchased.
Options for investment of tax loss selling proceeds
After the sale of the securities has taken place, what should the investor do with funds generated from the capital gain management? Three options are available to the investor
Option 1 – purchase an alternative security that is not considered a “substantially identical security”
Option 2 – purchase an Exchange Traded Fund (or ETF)
Option 3 – leave funds in cash or place funds into a money market.
All three are viable options; which one is best depends on the investor and their overall risk tolerance. Generally, if the investor believes the market is in the process of an upswing, the investor may prefer to go with option number 1 or 2 so their money is invested and they can take advantage of the up market. When pursuing option 1, the investor will attempt to replace the security with a security that has similar risk/reward characteristics. Ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation. If the investor sold stock in Company 123 and then purchased Company 456 in the same industry, the IRS would not consider the purchase of Company 456 as a violation of the wash sale rule. To successfully carry out capital gain management, you have to understand the wash sale rules.
What if the investor sold a portion of their mutual fund shares instead of individual stock? How would the IRS treat the selling of mutual fund shares? Ordinarily, shares issued by one mutual fund are not considered to be substantially identical to shares issued by another mutual fund. The investor could then sell shares of one mutual fund and purchase shares in another mutual fund with a similar investment style. In this scenario the IRS would not consider the sale a violation of the wash sale rules.
Better yet, what if an investor sells shares in a mutual fund for a loss and replaces them with a mutual fund or (ETF) that owns “substantially identical securities”; is this an acceptable transaction? The IRS does not provide a clear answer. If you were to sell IShares S&P 500 index (IVV) and then purchase Vanguard Large Cap ETF (VV), the tax loss could be disallowed. It is best to stay away from these types of transactions – swapping ETF for capital gain management.
The use of ETFs in option 2 is pretty straight forward when dealing with individual stocks. Selling an individual stock in Company 123 and replacing the stock with an ETF in the same industry or asset class is not considered a violation of the “substantially identical security” definition.
Like any investment tool, options 1 and 2 come with risk. Options 1 and 2 provide the investor with stock risk rather than market risk. What if the securities sold, outperform the alternative securities or the ETFs? This is a valid question and the investor will need to be willing to take on this stock risk when deciding whether or not to participate in capital gain management. If the investor is not willing to take on the stock risk in buying alternative securities or ETFs; the investors should consider option 3 – leaving the funds generated by the capital gain management in cash or investing in a money market fund. On day 31 the investor may then reenter the market without restriction.
Leaving the funds in cash protects the investor from potential declines in the market, but what if the market rallies? Part of the investor portfolio is not participating in the market upswing. Yes, the investor may enter the market at any given time using option 1 or 2, however timing the market is a science that no one has mastered. Chasing the market (buying into the market during a rally) could end up costing you more in the end than the tax benefit realized from capital gain management.
Another technique an investor may use to manage their capital gains for the year is called “Doubling Up”. “Doubling Up” is when an investor with additional cash or borrowed funds buys additional shares of a security and then sells the original position after 31 days.
The “Doubling Up” method generally works when a market has been down for a long period of time and the investor has a lot of large unrealized losses in their portfolio. The purchase of additional securities by the investor will allow the investor, after 31 days, to shift their cost basis from securities purchased at high tax basis to securities with a lower tax basis; thus recognizing losses in the portfolio while still holding an investment in the security.
Example: An investor has 1,000 shares of Company 123 with a $20,000 cost basis; the current market value of stock in Company 123 is $5,000. The investor currently has $15,000 of unrealized losses. The investor purchases an additional 1,000 shares of Company 123 for $5,000. The investor now owns 2,000 shares of Company 123 with a cost basis of $25,000 and a market value of $10,000. In 31 days the market value of Company 123 increases in value to $10,500. The investor will then sell the original 1,000 shares of Company 123 for $5,250 with a cost basis $20,000. After the transaction the investor will now have a realized loss of $14,750 and still have 1,000 shares of Company 123, but with a cost basis of $5,000.
Sounds easy right? Not exactly, the investor takes on market and stock risk by “Doubling Up” on a security in their portfolio. What happens if the “Doubling Up” position decreases in value? It will cause the investor to incur additional losses in their portfolio. Before “Doubling Up” on an investment the investor should go through a detailed analysis of their portfolio and try to determine what the overall capital gains tax is and net present value cost benefit. An investor should perform a stress test to determine how much the stock would have to decrease in value before any tax benefit is offset. If the breakeven point is within reasonable ranges, it might be best to avoid this strategy.
Capital gain management is not for every investor, if your portfolio has a small amount of unrealized losses; capital gain management is not for you as transactional losses will outweigh any benefit. However, if your unrealized losses for the year are large; harvesting some of these losses is a good way to reduce your tax liability and offset future year tax rate increases. Capital gain management is not just a year-end strategy; the use of capital gain management throughout the year can help enhance the overall return in your portfolio through the effects of rebalancing.
As investors should have long term investment plans in place, a capital gain management strategy should be viewed in context with the overall investment plan. The use of capital gain management in a disciplined investment strategy should help increase after-tax returns of a well-diversified portfolio.
To ensure compliance with Treasury Circular 230, we are required to inform you that any advice concerning tax issues contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties that may be imposed by any governmental taxing authority or agency.