Did you have the foresight to buy Tesla? Netflix? Micron? If you picked one of these stocks or another high-flier, you are to be congratulated – though you may face a dilemma as a result of your good fortune.
Perhaps you feel that the Fed-induced stock market rally has run its course and would like to take some money off the table. But, you are reluctant to pull the trigger on a sale, knowing you will have to share a substantial portion of your gain with Uncle Sam.
If you have held your position for more than a year, your profit will be subject to taxation at the capital gains rate. If less than a year, it will be taxed at the more onerous ordinary-income rate, which could amount to as much as 50% of the gain.
Here’s the good news. If you own municipal bonds, chances are you already possess the solution to this predicament.
As we’ve discussed previously (“Good News, the Sky is Falling“), an avalanche of muni-bond fund redemptions this year forced managers to flood the market with bonds, resulting in substantial market-value declines. Stocks and certain other assets, meantime, have appreciated.
This combination of events has not occurred in recent years but currently offers an ideal opportunity for muni investors: a “tax swap.”
Although some long-term individual municipal bonds have decreased in value, we normally would not recommend a sale. The bonds are paying interest and have a stated maturity date with the promise to return principal. It’s not unusual for market values to fluctuate and it isn’t a problem for investors focusing on the chief advantage of munis – generating tax-free income.
In this instance, however, a sale makes sense. Here’s how it works: Investors cash out of their profitable assets and sell some muni bonds at a loss. They can use the proceeds at the same time to acquire other bonds. This enables them to take the loss for tax purposes, offsetting capital gains, dollar for dollar, (short or long term) without losing their position in the muni market or missing a day of interest. No other market affords this simultaneous opportunity without running afoul of the IRS “wash/sale rule.”
As we discussed recently (“When Flexibility Counts“), tax swaps demonstrate a significant advantage of high quality, long-term tax-free bonds. But they haven’t been implemented widely in recent years because over the last decade, most bonds were valued above their cost.
Keep in mind, even if you have no gains, you will want to avail yourself of this tool. The IRS allows you to offset up to $3,000 per year of your adjusted gross income and carry forward any remaining losses, dollar for dollar, into ensuing years.
2013 will bring a resurgence of this type of tax trading by institutions as well as individual investors. These trades become more difficult to implement late in the year as the December 31st deadline looms.
Please consult your tax professional to discuss how this strategy applies to your specific situation.
Now is the time to explore your options.