Bonds: Harvesting Losses

There are times when it can be beneficial to realize a loss for tax purposes. Losses can be used to help offset up to $3,000 of current income a year, and capital gains from other investments. They can also be "banked" or carried forward to another year if they can't be used in an existing tax year.

The value of these losses depends upon the taxpayer's marginal tax rate and the capital gains tax rate. The first $3,000 of losses may be used to offset ordinary income. Let's say the investor is in the 35% tax bracket. The value to him/her of this loss is: $3,000*.35%=$1,050. If the size of the loss is greater than $3,000, then the remaining loss can be used to offset capital gains. For example: if the loss is $8,000, there is $5,000 of losses remaining after using the first $3,000 against ordinary income . The value of using these losses to offset capital gains is $5,000*.15= $750. We use .15% as the capital gains tax rate. This rate is scheduled to expire in 2010 and return to the .25% previous rate. The total losses harvested in this example is $1,800 ($1,050 + $750). The higher the tax rate, the more value there is in the loss.

When realizing losses for tax purposes, it is important to remember the Wash Sale Rule. This rule states that when you take a loss on a security, you may not re-purchase the same security for 30 days in order to use the loss on your return. This rule is meant to discourage investors from selling a security and immediately buying it back. If you own stock in Microsoft and realize a loss, you can't buy back MSFT for 30 days and use the loss. What works best in tax loss selling is finding a security that is a good substitute for the security you are selling. Muni bonds are the ideal securities for tax swapping. For example, if you own City of Chandler, AZ 5% coupons due 1/1/2013, you could swap these for City of Scottsdale, AZ 5% coupons due 1/1/2013 in a legalized way around the wash sale rule.

The challenge in doing these types of trades is having low transaction costs. The typical retail client is locked into a buy and hold strategy because their transaction costs are too high. For example, it would not make sense to do the swap above if your cost of doing the trade is greater than the tax savings you generate. The typical bid/ask spread for a retail client is over 2%. If the investor has a $5,000 loss, it is worth $750 to him. If it costs him $2,000 to do the trade, then his position will be impaired $1,250 by doing the trade ($750 - $2,000). Thus, he is locked into a buy and hold strategy. If, however, your transaction costs are $0, then you can save $750 in taxes by doing the trade.

There is significant benefit for investors in knowing what their transaction costs are, and in finding ways to reduce them. The lower the transaction costs, the more beneficial tax loss harvesting becomes. This will result in higher portfolio returns both before and after tax.