Easing the Pain of Gains

Despite the movement higher in yields, investors may continue to hold fixed income investments with embedded losses.

For investors looking to reduce their tax burden, the practice of tax loss harvesting can be used to help offset taxes from capital gains, by selling investments that have experienced losses. This strategy potentially increases the overall tax efficiency of an investment portfolio.

The potential benefits of tax loss harvesting may be even better for investors in municipal bonds. By applying tax loss harvesting to a municipal bond portfolio, investors don’t simply defer capital gains tax liabilities. The goal is to eliminate capital gains taxes completely.

What is tax loss harvesting?

As investors realize capital gains on their investments, tax liabilities accrue. The resulting tax bill can be substantial when assets have significant embedded unrealized capital gains.

Tax loss harvesting is a practice that allows investors to reduce or eliminate accrued tax liabilities by selling securities that have depreciated in value and then using the losses to offset capital gains elsewhere in their portfolio.

Why harvest losses from municipal bonds?

For fixed income investors, tax loss harvesting can potentially be even more tax efficient than using the same process with other asset classes. Unlike applying tax loss harvesting to some other asset classes, which may simply defer the payment of taxes into the future, municipal bond investors can utilize tax loss harvesting to potentially eliminate tax liabilities.

For example, selling a stock at a loss may initially generate a capital loss for tax purposes that can offset gains elsewhere in a portfolio. But if the proceeds from selling that stock are used to purchase another stock that is later sold at a profit, capital gains – and a resulting tax liability – will be realized. In effect, the investor has only delayed paying capital gains taxes. 

Compare that with a bond. As fixed income securities, including municipal bonds have finite lives, they operate differently than perpetual securities. Assuming bonds are held until maturity, tax loss harvesting can reduce, or potentially eliminate, current tax liabilities — without creating or increasing future tax liabilities.

Consider this example involving municipal bonds:

• The municipal bond has an adjusted cost basisof $120.
• The municipal bond has a market price of $110 upon sale for a $10 loss that can be used to offset realized capital gains elsewhere in the portfolio.
• Upon sale, proceeds from the first municipal bond are reinvested in a similar bond with an identical maturity date, priced at $110.

When the second bond matures, there are no capital gains incurred because the purchase was executed above par and the bond matured at par. However, there is still a valuable $10 capital loss realized on the original holding, which can be used to offset gains generated elsewhere in the portfolio. If the original bond had simply been held to maturity, no such realized loss would exist.

Investors should consult their tax and/or legal counsel for specific tax or legal questions and concerns prior to engaging in tax loss harvesting.

Why is market liquidity important?

In our view, tax loss harvesting is most effective in highly liquid markets where there are bonds available that can be purchased at a premium. Fortunately, municipalities typically issue high-coupon bonds at significant premiums above par precisely because they are highly tax-efficient structures.

In addition, the municipal marketplace has an abundance of issuers – and plenty of issuance. This allows for timely reinvestment while avoiding triggering wash sales that can offset the benefits of tax loss harvesting.

What are the benefits of a technology-driven approach to tax loss harvesting?

We believe tax loss harvesting is best handled by experienced investment professionals who know how to harness technology to deliver the best results for investors.

Below are some of the key advantages of a technology-driven process for municipal tax loss harvesting:

• Efficiently identify securities across eligible municipal bond accounts that may be appropriate for tax loss harvesting.
• Help add after-tax value by analyzing the liquidity, yield, and structure of identified securities on a bond-by-bond basis.
• Aggregate blocks of identical CUSIPs held across multiple eligible accounts in an effort to deliver superior execution.
• Avoid triggering wash sales (buying a ‘substantially identical’ security within 30 days of selling a security at a loss), which can negate the potential benefits of tax loss harvesting because the loss will be disallowed.

Tax loss harvesting can potentially increase the tax efficiency of a municipal bond investor’s portfolio. However, timing, technology, and the right partnership are keys to benefiting from this time-tested investment technique.

Consulting with a financial advisor or tax professional can help investors navigate the complexities of tax loss harvesting to ensure that the decisions they make align with their overall financial goals.