A Season to Harvest

As we enter the holiday season, we are reminded that the first Thanksgiving was a celebration of new opportunities, new freedoms, and a bountiful harvest.

For wise investors, thoughts of the “harvest” may quickly lead to a conversation with their advisors regarding potential tax-loss harvesting and other year-end planning techniques. The advisor will then most likely scan through their taxable accounts looking for holdings that have decreased in value since their purchase date. Disposing of these positions can generate capital losses to offset against any capital gains they may have been lucky enough to generate over the year. For the last few years, finding loss positions to harvest has not been a very difficult task, and many investors are likely to have generated excess capital losses, of which $3,000 can be used to offset ordinary income in the current year with the rest being carried forward to offset future year gains. While most perceive this simple strategy as a relatively routine year-end tax saving task, we encourage our clients to give this annual process strong consideration and work with their tax and investment advisors to more appropriately weigh any investment implications of the loss harvesting as well as the potential tax benefits of any year-end planning. The items addressed below present a brief snapshot of issues that frequently arise during the year-end investment planning process, but should be addressed with your advisors throughout the year.

Be Aware of Wash Sale Rules

Before implementing any loss harvesting, investors should be careful to avoid the tax trap known as the “wash sale” rules. In short, this set of rules prohibits claiming a loss on the sale of a capital asset if the same or a substantially similar asset is purchased within 30 days (before or after) of the transaction. Any loss disallowed under these rules increases the basis of the newly acquired asset, effectively putting the taxpayer back in the same tax position as before the sale. For investors with multiple accounts and multiple managers, these rules can quickly erode any expected current-year tax benefit of the loss harvesting in the absence of diligent planning.

One alternative for investors looking to effectively harvest some tax losses while maintaining their investment strategy is to “double-up” on the investment position they anticipate selling for a loss by acquiring an equal number of shares or units outside of the wash sale window (31 or more days prior to the planned sale). Clearly, this requires advance planning and carries some risk that the price of the security could continue to deteriorate, compounding the loss position to the investor. On the other hand, if the price of the stock or fund remains level or appreciates, the loss positions can be sold and the loss taken without concern of the wash sale rule limitation. This strategy is frequently engaged in by investors with a great deal of conviction or emotional attachment to a particular position who do not want to reduce their position in the underlying investment.

In contrast, investors who are not as particular about the specific security can plan around the wash sale rules by identifying and acquiring a position considered to be closely correlated with, but not “substantially identical” to, the position that was (or will be) sold. This option also allows the investor to capture more of any favorable price movement of the asset that was (or will be) sold. However, like the strategy described above, this approach is not without risk. Specifically, due to the IRS’ ambiguity and inconsistency on the definition of “substantially identical," consulting both competent tax and investment professionals on this matter is highly recommended.

Mutual Fund Distributions

Whenever rebalancing a portfolio includes plans to purchase a mutual fund, it is important to consider the timing of the purchase. Each year at year end, a mutual fund is required to distribute to its shareholders all net capital gains created by the sale of securities within the fund. This may result in a higher tax liability for the mutual fund owner who is required to pay tax on this capital gain distribution even if the proceeds are reinvested in the mutual fund. If purchasing a mutual fund in the fourth quarter in a taxable account, investors should consider postponing the purchase until after the distribution is made to avoid incurring tax on the distribution.

Tax Rate Considerations

Minimizing overall tax liability is the purpose of tax loss harvesting, but another consideration especially important right now is what is likely to occur to tax rates in the coming years. The Obama Administration has recommended that the current top 33 and 35 percent tax brackets be increased to 36 and 39 percent respectively. Long-term capital gains rates are also expected to increase from the current 15 percent to 20 percent, which is still a historically conservative level for long-term capital gains rates. Accordingly, it is even more important for investors to consider changes in tax rates as part of the year-end investment planning. Rather than harvesting the loss this year, it may be more prudent to wait if the loss position can be used against gains that may be taxed at higher rates.

Gifting (Charitable or Otherwise)

Finally, for investors considering a disposition of a concentrated position in low basis stock, gifting or donating portions of those positions is another effective way to hedge against potentially escalating future capital gains rates. Consultation with a tax advisor regarding the income tax and gift tax implications of gifting or donating significant assets is crucial and should be done prior to making the gift. However, if diversification is the principal objective of the disposition, donating low basis stock in appropriate taxable years can help to both lower your taxable income as well as reduce the unsystemic risk associated with the concentrated holding.

As 2009 comes to a close, year-end investment and tax planning may prove to be anything but straightforward due to the erratic behavior the capital markets have exhibited during the last 24 months and the forthcoming political landscape. The extreme downturn in the stock market from late 2007 through early 2009 and the acute rebound to date combine with the uncertainty of future tax rates to provide a more challenging decision for investors who are just now planning year-end investment analyses and considering rebalancing their investment portfolios. However, as we have certainly noted before, the recent volatility creates an ideal time for investors to re-evaluate their investment strategies and examine what role tax strategy will have on their plans.