HOFFMAN,
WHITE & KAELBER FINANCIAL SERVICES, LLC
Investment
managers & WEALTH Advisors
December 7, 2006
This is the December 2006 monthly Wealth Management
newsletter from Hoffman, White & Kaelber Financial Services, LLC. If you do not wish to be included in our
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The Tax-Loss Harvesting Conundrum
Are you
familiar with the concept of tax loss harvesting? Simply put, it is the process of selling
securities at a loss to offset taxable gains elsewhere in an investor’s
portfolio. By many, this is considered
to be an opportunity that can offer substantial tangible benefits to high
income taxpayers. And the potential for
savings can be extremely seductive.
However, in
the complex worlds of investing and taxation, tax-loss harvesting is not always
as simple as it seems and the benefits garnered can vary widely. Sometimes in ways that are not readily
apparent.
When one
scours the internet, as I have, for information relating to tax-loss
harvesting, what you’ll find is an abundance of literature promoting the tax
benefits that can be garnered. It should
come as no surprise that much of the information is written by tax experts who
are zealously dispensing advice with little regard to the investment
implications. With modest caveats, the
greatest caution often provided relates to making readers aware of the “wash
sale” rules that are a part of the tax code for which you must coordinate this
maneuver. We’ll talk about the “wash
sale” rules later.
Numerous
references were found, similar to investopedia.com, saying: “if properly
applied, it can save you taxes...” Aside
from the constant use of those words “if properly applied”, few articles provided
readers an appreciation for the combined cost-benefit relationship of doing
so. In fact, almost no one offered a
perspective of the varying degrees of utility garnered from tax-loss harvesting
or the impact to your strategy of investing.
Wait! Doesn’t this concept of
tax-loss harvesting seem to be encouraging us to sell investments lower than we
bought them? Doesn’t that seem
counter-intuitive to what we should be doing to create wealth? I thought “buy low” and “sell high” was the
proper formula for success. Isn’t it?
Actually,
it makes perfect sense to sell for a tax-loss when we have an investment that
no longer offers promising potential relative to other alternatives in the
market place. It may also make sense
when we can substitute an investment for another that offers similar
opportunity for gain and risk taking.
Nevertheless, when not approached thoughtfully, tax-loss harvesting can
easily turn afoul when one doesn’t consider the investment as part of the
strategy. “One of the primal fears of
clients and advisors”, says Jeremy Held, regional sales manager for the Select
Sector SPDRs, “is as soon as an underperforming investment is sold at a loss,
the investment will bounce back in price.”
As readers of our newsletter well know, wealth management is
the ultimate goal of all that we do at Hoffman, White and Kaelber. Yes, we promote our services; yet, you will
find that we always seek to present thought provoking topics that are relevant
to our wide audience.
This
month’s newsletter will discuss tax-loss harvesting and provide you some food
for thought on how to blend your investment and tax advice. If you are an investor with a taxable
account, you should come away with a broader understanding of how you may
optimize your after-tax returns. Once
you’ve read this timely written piece, please be sure to spend some time
looking over our market comment and performance for the month past. It will be well worth the investment.
The “Wash Sale” Rules
First off,
the “wash sale” rules apply to
The
following excerpts, in italics, come
directly from the current IRS Publication 550 at the time of this writing:
A wash sale occurs when you sell or
trade stock or securities at a loss and within 30 days before or after the sale
you:
If you sell stock and your spouse or
a corporation you control buys substantially identical stock, you also have a
wash sale.
There are
also “wash sale” rules that cover options, warrants and futures contracts that
must be considered for more sophisticated strategies.
Substantially
identical.
In determining whether stock or securities are substantially identical,
you must consider all the facts and circumstances in your particular case. Ordinarily, stocks or securities of one
corporation are not considered substantially identical to stocks or securities
of another corporation. However, they
may be substantially identical in some cases.
For example, in a reorganization, the stocks and securities of the
predecessor and successor corporations may be substantially identical.
Similarly, bonds or preferred stock
of a corporation are not ordinarily considered substantially identical to the
common stock of the same corporation.
However, where the bonds or preferred stock are convertible into common
stock of the same corporation, the relative values, price changes, and other
circumstances may make these bonds or preferred stock and the common stock
substantially identical. For example,
preferred stock is substantially identical to the common stock if the preferred
stock:
Short sales. The wash sale rules apply to a
loss realized on a short sale if you sell, or enter into another short sale of,
substantially identical stock or securities within a period beginning 30 days
before the date the short sale is complete and ending 30 days after that date.
For purposes of the wash sale rules,
a short sale is considered complete on the date the short sale is entered into,
if:
Otherwise, a short sale is not
considered complete until the property is delivered to close the sale.
How to report. Report
a wash sale or trade on line 1 or line 8 of Schedule D (Form 1040), whichever
is appropriate. Show the full amount of
the loss in parentheses in column (f). On the next line, enter “Wash Sale” in column
(a) and the amount of the loss not allowed as a positive amount in column (f).
Maximizing the Tax-Loss Harvesting Strategy
In October
2004, the
“Definition:
Realizing capital losses for tax purposes to offset any other gains an investor
may have. Tax harvesting may:
·
Bring
capital gains taxes down to zero,
·
Generate
a $3,000 ordinary tax-loss deduction, and/or
·
Create
loss carry-forwards for subsequent years
Research
Questions
·
At
what price should an investor harvest a loss?
·
How
much is tax-loss harvesting worth to a taxable investor?
·
What
factors influence the answers to the above?
·
How
large are the effects of these factors?”
Now, in
answer to some of these questions, let’s consider some additional information.
On the
taxation side of the equation, presuming you successfully maneuver through the
wash sale rules, the maximum tax rates for short-term capital gains are higher
than for long-term capital gains. To not
let this get too technical, I’m going to assume that you understand what a
capital asset is and what creates a capital gain or loss. However, whether a capital gain is classified
as long-term or short-term is worth noting.
The IRS classifies a long-term capital gain as realized when coming from
a capital asset that is held more than twelve months before being sold. This is a fairly important concept all by
itself.
Under the
On the
investment side of the equation, evaluating what to sell and when is far less
certain and an error in judgment can quite often cause more loss than the tax
benefit sought. Keep in mind that you’re
reclaiming 35 cents on the dollar from federal taxes against short-term gains
and 15 cents per dollar from long-term gains.
This is where you really need to factor in your opinion for the
potential of the investment with the tax benefits you are seeking. Why is this so?
Most
investors understand that some investments, especially in the case of
individual stocks, are generally more volatile than others. By this, we mean that some investments can
fluctuate 3% or more in a single day; while others may not fluctuate more than
1% in an entire month. If you have a
shallow loss relative to how that investment may fluctuate, it may not be a
good idea to realize the loss.
Especially, if it has the potential to recover one or two days after you’ve
sold it. However, if you’re looking at a
much deeper loss, you’ll probably want to reconsider the overall merits of the
investment and whether your reason for owning it remains consistent with your
reasons for purchasing it to begin with.
If the fundamentals of the investment have taken a long-term trend for
the worse, then tax-loss harvesting clearly makes sense.
As an
alternative, if you can find a substitute investment that is not substantially
identical under the wash sale rules but which offers substantially similar
opportunity for gain, then you might want to consider it. Fixed income investments are often better
suited for this than equity investments.
However, be aware that not all investment opportunities are easily
substituted with any level of precision.
In Conclusion
As
mentioned at the start of this letter, tax-loss harvesting can offer
substantial tangible benefits to high income taxpayers. And it can make perfect sense to sell for a
tax-loss when we have an investment that no longer offers promising potential
relative to other alternatives in the market place. It may also make sense when we can substitute
an investment for another that offers similar opportunity for gain and risk
taking. Nevertheless, when not
approached thoughtfully, tax-loss harvesting can easily turn afoul when one
doesn’t consider the investment as part of the strategy.
Our clients
can take comfort that we have substantially harvested tax-losses for our clients
when we updated our asset allocations in the latter half of this year.
Hoffman, White & Kaelber Financial Services Investment
Performance Update
During November, the economic data that seemed to have the
largest impact to
In mid to late October we repositioned our portfolios and increased
our international exposure. On top
of gaining value from a falling dollar, we began to favor selected global
ETF opportunities in technology, financials, business services and natural
resources. In seeking value, one of
the criteria that appealed to us were opportunities where the ETF exposed
us to cash rich companies with relatively lower debt levels. At the same time, we have closed out all of
our short positioning and are currently managing our portfolios long only. While it is more than clear that the
For the month ended November 30, 2006, our
one-month performance is up 3.87%, our one-year return is up 7.20%, our
three-year return is up 5.66% and our average annualized return since inception
is up 8.67%. Our since inception risk
measures edged upwards slightly, but remain very conservative at +/- 5.92%
(+/- 6.69% and +/- 6.09% for one-year and three-year measures, respectively)
and our since inception Sharpe Ratio (reward for risk taken) remains very respectable
at 1.02.
For more
performance information, please see our web site for details.
Is a comfortable retirement or preservation of wealth important to
you?
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Research us on the web at www.hwkfs.com