You may see some significant tax benefits by making these moves.
The end of 2018 presents bond investors with opportunities. This is a prime time to consider bond swaps (or tax swaps as they are sometimes called), in which you sell certain bonds at a loss and replace them with others. Every investor wants to lessen his or her tax liability, and this is one way to pursue that goal.
At their core, bond swaps are not complicated. You just sell one bond and use the proceeds from the sale to buy a similar bond. You can use the capital loss you take to counter a capital gain elsewhere. In fact, when you sell securities at a capital loss like this, you also have the option to use the losses to offset up to $3,000 of regular income.1,2
The debt securities involved in a swap must not be identical. In fact, they cannot even be “substantially identical.” If they are, then the swap violates the “wash sale” rule created by the Internal Revenue Service.1
Under the wash sale rule, you cannot sell bonds and then replace them with identical (or substantially identical) bonds within the next 30 days. You are also prohibited from making that move in the 30 days before the sale. Generally, you are in the clear if two of the following three characteristics differ among the two bonds involved: the coupon (i.e., the bond’s annual interest rate), the issuer, or the maturity.1
You may want to swap bonds not only for tax efficiency, but also for other reasons. Do you want more yield? Perhaps you can sell some bonds and replace them with an equal amount of bonds bearing a slightly higher coupon rate that matches the higher interest rates in the markets.
In fact, you may want to swap debt instruments in anticipation of future interest rate trends. Municipal bonds issued after a Federal Reserve interest rate hike, for example, could gain value in the future if the Fed shifts its monetary policy outlook at some point and begins to ease.3
Additionally, you may want to try and swap a low-rated debt security for a higher-rated one (this may be a savvy move if a recession seems near).
You can also perform tax swaps with stocks, of course. Every year, investors sell underperforming shares in their stock portfolios and take either short-term or long-term capital losses; this process is commonly called tax-loss harvesting, and the wash sale rule described above applies. The prime candidates are shares currently worth less than their cost basis: that is, what you paid for them, plus any commissions you paid, plus the reinvested dividend and capital gains distributions.2
Swaps only make sense for investments held within taxable accounts. It should be obvious why: annual capital gains of investments held within tax-sheltered accounts (such as IRAs) are exempt from taxation for as long as the investments remain in them.4
Investors usually arrange year-end tax swaps with one or more of the following goals in mind: greater tax efficiency, better portfolio diversification, or a better rate of return. An astute series of bond (or stock) swaps might allow you to achieve one, two, or three of those objectives.
1 – investopedia.com/terms/t/taxswap.asp [11/5/18]
2 – morningstar.com/articles/889941/taxloss-selling-a-silver-lining-in-volatile-market.html [11/1/18]
3 – investopedia.com/articles/investing/110615/5-reasons-invest-municipal-bonds-when-fed-hikes-rates.asp [10/9/18]
4 – finance.zacks.com/capital-gains-losses-401k-rollover-ira-treated-9594.html [5/29/18]