Near the end of each year, we like to remind clients of a potentially rewarding but simple investment strategy: The tax swap.

We focus on it at year-end because that’s when many investors assess their financial picture and begin thinking about their upcoming tax liability (“Year-End Muni Tax Swap”).

This year, however, extreme volatility in stock and bond prices and extraordinary muni yields have prompted many investors to take advantage of the tax swap strategy now.

Usually, buy-and-hold

Most successful investors buy and hold their municipal bonds until they mature or are called. After all, when investing in munis, the goal is to maintain a steady, dependable stream of tax-free income, not generate capital gains.

They expect swings in the market prices of their holdings. Munis pay tax-free interest with a stated maturity date and the promise to return principal – that’s what’s important to investors, not temporary market fluctuations.

This year, however, is different.

Chaos reigned

In early April, amid dramatic tariff announcements, reversals and otherwise chaotic signals from the White House, the municipal bond market experienced a significant selloff driven by volatility in the Treasury market. During a three-day stretch, for example, yields on benchmark 10-year Treasuries rose 53 basis points.

Amid broad market anxiety and investors’ flight to cash, institutions had to sell to meet margin calls. Some municipal bond investors sought to raise liquidity for tax payments.

Crucially, the selloff wasn’t about credit fundamentals.

“Is this the result of concerns about credit quality?” Schwab asked in a recent report. “We don’t believe so. Credit conditions for most issuers have improved over the past five years.”

“We believe this is mostly a technical (supply and demand) issue,” the firm said, echoing other analysts.

Why a tax-swap makes sense

It is precisely in this environment that a tax swap, a form of tax-loss harvesting, can make sense. Here’s how it works.

Consider an investor who would like to cash in on gains earned in the stock market and who also owns municipal bonds whose market price has flagged.

If she cashes in both, the sale of the bonds will cushion the tax blow of the stock sale, and at the same time she can use the proceeds of the sale to acquire other municipal bonds at today’s lofty yields.

The investor can take the loss for tax purposes and offset capital gains, dollar for dollar – short or long term – without losing her position in the municipal market or missing a day of interest.

No other market affords investors the ability to do this at the same time without running afoul of the IRS “wash/sale rule.” Investors should know that to avoid the wash/sale rule, they must purchase a “substantially different” bond than was sold without sacrificing a day’s interest.

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 subsequent years.

Simple, rewarding strategy

While muni yields have eased in recent days, they are still at remarkable levels. For example, the tax equivalent yield recently of an A-rated municipal bond was 8.31% for investors at the 40.8% tax rate.

Recently, the AAA-rated muni-bond-to-Treasury-ratio was an astronomical 93%, or the taxable equivalent of 157% for taxpayers paying the 40.8% rate.

Through a tax swap, investors can minimize the tax impact of selling profitable assets while securing high-quality, long-term municipal bonds – a simple and potentially rewarding strategy to unlock tax savings, boost returns and strengthen investors’ muni portfolios.

To determine how this strategy applies in your specific situation, consult your tax professional.

From there, we can help you take advantage of a potentially lucrative opportunity.