Fixed Income Q&A: How to effectively harvest tax losses in bonds?

Posted by The Dopkins Wealth Team | Aug 19, 2014 1:53:36 PM

Q: How can you effectively harvest tax losses in bonds? 

A: The prospect of higher interest rates scares a lot of investors as that can mean lower bond prices and the potential for losses. You can, however, take advantage of these losses to help improve the overall portfolio return. 

municipal-bond

The simplest, most effective way to take advantage of these municpal bond losses is by harvesting them through a “tax swap.” This involves selling an individual bond to book a loss and immediately purchasing a similar, but not identical, bond at a higher yield with the proceeds of the sale. Again, the new bond cannot be identical to the original. Wash sale rules apply to the equity and fixed income markets. For a hypothetical example of a tax swap:

Sell Side                                       Buy Side                           
Description: Oakland County, Mich   Description: New York City
Coupon: 3.00%    Coupon: 5.00%
Maturity Date: 11/1/2022   Maturity Date: 8/1/2022
Rating: Aaa    Rating: Aa2
Sale Price: 102.944    Purchase Price: 116.909
Give-Up Yield: 2.62%   Purchase Yield: 2.72%
Net Proceeds: $781,267.50   Net Proceeds: $782,709.43
Net Loss: $29,575.06    

We are selling the Oakland County muni bond at a yield of 2.62 percent for total proceeds of $781,267.50, which captures a loss of $29,575.06. We then use the proceeds plus an additional $1,441.93 of cash to purchase a New York City issue at a yield of 2.72 percent. The additional yield along with the tax benefits of the loss we harvest give us a net benefit of $7,895. Obviously, part of this benefit is the loss we harvested. This allows us to offset future gains in the portfolio or to lower a client’s ordinary income up to $3,000.

Remember that we need to consider the loss and the yield we could be sacrificing. This is important because if the yield we give up is substantially more than our replacement yield, the value of the tax loss will be wiped out by the loss in yield.

How big of a loss do we need before we explore a tax-loss harvest? There is no “right” answer, but we like to use a loss threshold of at least $5,000 as well as 5 percent or more of the overall value of the bond. A loss of this size ensures the net benefit to the overall portfolio will be meaningful and not significantly eroded by trading costs.

 

 

 

 

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Copyright © 2014, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.

Topics: fixed income, municipal bonds, muni bonds, tax swap, investing in bonds, dwm, dopkins wealth management

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The Dopkins Wealth Team Dopkins Wealth Management (DWM) is an investment advisory and consulting firm that specializes in providing comprehensive wealth management services by incorporating tax planning, business succession planning, wealth preservation, and wealth transfer into our investment strategies and fiduciary-based solutions. Whether it’s an individual, institutional investor, Corporate 401k plan, foundation or endowment, our clients benefit from our use of an investment strategy grounded in academic research that focuses on long-term success. The key to our client’s success is our ability to understand their unique financial goals and needs, and integrate that with their need, ability, and willingness to take risk to formulate a long-term plan for financial security and prosperity. For more information, contact Tom Emmerling at temmerling@dopkins.com.

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