In all of my years working with electrical professionals I’ve yet to meet someone who likes paying taxes. We all know that it’s a part of life but it seems that the more successful we become and the older we get, it becomes more of an issue. Many people I work with benefit from investing in tax-free bonds and the tax benefits that are associated with them. But what if you own equities? Like most investors, you have probably been cheered by the market rally we’ve seen since March 2009. Yet, despite this dramatic reversal of fortune, you still may own investments that have lost value since you purchased them. If that’s the case, you may want to put these “losers” to work before 2010 ends. How? By using them in “tax swaps.”
Let’s take a quick look at how tax swaps work. Suppose your shares in XYZ Corporation have lost value since you purchased them three years ago. You decide to sell these shares so that you can use the tax loss to offset some capital gains you may have realized in other investments. If you don’t have any capital gains, you can use up to $3,000 of your tax losses in XYZ to offset other ordinary income. If your loss is greater than $3,000, you can “carry over” the excess and deduct it from your taxes in future years.
So far, so good. But you discover one problem in your strategy — you like owning shares in XYZ Corporation because you think it has good prospects for long-term growth and it fits well into your portfolio. But couldn’t you just sell your shares and then immediately repurchase new ones in XYZ?
You could — but you’d be violating the Internal Revenue Service’s “wash sale” rules, which prevent you from claiming the tax loss if you sell an investment and replace it with a substantially identical one within 30 days before or after the sale date.
So what are your options? You could, of course, simply sell your shares of XYZ, wait 31 days and repurchase them. However, you need to realize that, during those 31 days, the price of XYZ may well increase, so you’d have to pay more for your shares. But if you can benefit from the tax loss, and you really want to own XYZ, you may be prepared to accept this risk.
Keep in mind that you can also make tax swaps with bonds. The same wash rules apply, so if you sell one bond at a loss and purchase another within the 60-day wash rule period, the new bond can have similar, but not identical, characteristics to the one you sold. To illustrate: you could sell a 20-year, triple-A rated municipal bond and replace it with another triple-A rated municipal bond, but with a different issuer, coupon rate or maturity date.
Before making any tax swaps, it’s essential that you consult with your tax advisor to ensure that you’ll get the benefits of a tax loss without violating wash sale rules. And given that 60-day wash sale “window,” you’ll need to act quickly to take advantage of any tax swaps this year — so get together soon with your tax advisor and your financial advisor to see what type of investments are good candidates for swapping within the context of your overall financial strategy. It’s important to look at these types of strategies because chances are we will see increased taxes in the upcoming years.