Tax Swap End-of-Year Option

Klotz on Bonds

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<h3>James A. Klotz</h3>

James A. Klotz

An increasing number of municipal bond investors are taking advantage of an opportunity presented by the topsy-turvy stock and bond markets this year.

Known as a tax swap, it’s a potential win-win for investors looking to ease the tax burden of cashing out of profitable assets while acquiring high quality, long-term municipal bonds.

Not only are more investors participating in it this year, according to The Bond Buyer, but market conditions have prompted investors to begin doing it earlier in the year.

We discussed tax swaps previously when conditions were ripe (“How to Gain From a Loss”), and we see similar circumstances today.

Tax swap end of year option

Swap bonds

The idea behind tax swaps, a form of tax-loss harvesting, is to help soften the financial blow of unloading profitable investments. For assets held more than a year, the profit is subject to tax at the capital gains rate. If held less than a year, they are taxed at the ordinary-income rate.

Enter municipal bonds.

We normally don’t advocate investors sell their municipal bonds before they mature or are called. Nor do we usually suggest they sell if their market price dips. After all, the bonds are paying interest and have a stated maturity date with the promise to return principal. Investors buy bonds to reap a steady stream of tax-free income. Market fluctuations are immaterial.

This year, however, with significant swings in the stock and bond markets, investors can use the change in market values wisely. Consider the following scenario.

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    An investor cashes out of her profitable assets and sells some municipal bonds at a loss. At the same time, she can use the proceeds to acquire other bonds. This enables her to take the loss for tax purposes and offset capital gains, dollar for dollar, (short or long term) without losing her 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.” To avoid the wash/sale rule, investors must purchase a “substantially different” bond than was sold.

    End-of-year approaching

    It is important to note that investors can use this tool even if they have no gains. The IRS allows investors to offset up to $3,000 per year of adjusted gross income and carry forward any remaining losses, dollar for dollar, into ensuing years.

    We have helped clients implement this strategy for decades and expect activity to accelerate through year end. It should be noted, however, these trades become more difficult to execute as the Dec. 31 deadline approaches.

    As always, consult your tax professional to discuss how this strategy applies in your specific situation.

    There are potentially lucrative options to explore.

    James A. Klotz is the President of FMSbonds, Inc.
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    Nov 29, 2023

    Please note that all investing entails risk. Fixed income securities are subject to risks that will affect their value prior to maturity. Some of these risks can be related to changes in market conditions, issuer creditworthiness, and interest rates. This commentary is not a recommendation to buy or sell a specific security. All references to tax-free income refer to U.S. federal income tax. Income earned by certain investors may be subject to the Alternative Minimum Tax (AMT), and or taxation by state and local authorities. Please consult with your tax professional prior to investing. For more information on these topics please click on the “Bond Basics” link below or search by keyword at the top of this page.