As the end of the year approaches, advisers will be looking to minimize clients' tax liability and shift as much of the tax burden into the future as possible. What they may not know, however, is that this year, in particular, is ideal for furthering that objective by taking advantage of tax swaps, particularly bond swaps.
This year presents a “perfect storm” of sorts, an optimum environment for bond swaps because while bond prices have suffered due to rising interest rates, equities, real estate and other capital assets have achieved significant gains.
Most advisers today have experienced a one-way bond market for their entire careers, so taking advantage of a perfect storm like this may be uncharted territory for them. Nearly every year since 1982, bond assets have gone up in value because yields have gone down in a very long, secular trend.
For advisers who haven't experienced a bear market in bonds and are unfamiliar with bond swaps, the technique involves the sale of a bond or bond fund assets and the repurchase of other bonds, unit investment trusts or bond funds. This recognizes a loss while immediately replacing the asset with a like asset. Simultaneously, the investor sells and repurchases the capital asset with the gain, thus recognizing the capital gain. The gain is paired with the loss and neutralizes the current tax liability. Any taxable gain is effectively postponed into the future, and the investor essentially retains a portfolio similar to the one with which he or she began.
The key to using tax swaps successfully is to avoid violating the wash sale rule, which essentially prohibits an investor from generating a tax loss by buying and selling the same asset within 30 days. The rule was implemented by the IRS to prevent investors from selling a capital asset, then buying it back immediately with the sole purpose of triggering the capital loss. Running afoul of the rule means the loss is disallowed, the gain stands and the client owes taxes on the gain. Bonds, UITs and funds can steer clear of violations by using safe harbor rules.
While advisers should consult tax experts before engaging in tax swaps, there are some basic scenarios they might want to consider.
With a bond swap, for example, a client might buy a bond at par that's due in 10 years, has a 3% coupon and a current value of 80 cents on the dollar. If the investor sold that bond, he or she could take the 80 cents and buy another bond by another issuer with a slightly different coupon. That bond might have a 2.9% coupon, come due in 11 years, and cost the investor 78 cents on the dollar.
Ideally, the investor will end up with the same yield in the portfolio and a very similar maturity, with the same quality of obligation. The investor would take that 20 cent loss and pair it against a gain in an appreciated asset.
The preferred swap would be selling an equity that has run up in price and pairing it with a bond swap. The benefits of the strategy aren't limited just to owners of individual bonds. They also work for owners of bond mutual funds, or any capital asset that is taxable and in the hands of the taxpayers.
Advisers should consider moving from bond mutual funds to individual securities that have a maturity date or they may want to use UITs, which are prepackaged portfolios. They could also swap a taxable bond portfolio for a tax-exempt municipal portfolio. Or they could go from investment grade to junk bonds to increase the income.
It's important to be aware that tax swaps are not for everyone. The client must have a tax situation where there is enough benefit to execute the swap and have competent tax and investment counsel to reach the desired result, and to ensure he or she is not violating the wash sale rule.
Also, advisers need to look into this strategy now, as timing can greatly affect the outcome. Investors who wait until the last few weeks of December may be confronted by the adverse effects of limited trading capacity, mutual fund selling and other investors dumping year-end positions on the markets.
Scott Colyer is chief executive officer and chief investment officer of Advisors Asset Management Inc.