It's that time of the year to sadly sit and accept some reality and see if there are any strategic tax losses to offset trading gains. That is a gift in the tax code and just about the only thing that makes taking a loss palatable for me.
Before I go on, I'm not an accountant. I'm not even a Pediatric Dentist anymore. I'm not really certain what I am, other than to be someone faced with the same pragmatic issues as most investors, even in a year that everything seemed to just go higher and higher in share price.
Before considering what strategic tax losses I may decide to take this year, as the calendar is growing short, I find it useful to look back in time at the tax loss selections in 2012.
The strategic tax loss sales I sustained last year were on specific lots of Chesapeake Energy (CHK), sold at $17.36, Hewlett Packard (HPQ) at $13.66, ProShares UltraShort Silver (ZSL) at $51.09, Groupon (GRPN) at $4.79 and Potash (POT) sold for $40.07. The fact that other lots of those stocks may have delivered profits in 2012 is irrelevant and didn't soothe the angst of parting under such sad circumstances.
So where are those stocks now after a year that has seen about a 28.5% gain in the S&P 500? Is there life after loss?
Their closing prices on December 24, 2013 were: Chesapeake Energy ($27.61), Hewlett Packard ($28.18), ProShares UltraShort Silver ($90.02), Groupon ($11.83) and Potash ($32.82).
With the exception of Potash, all of those have had more than a 28% gain from their sales price and, in fact, more than a 28% gain from their purchase prices, as well.
The reason this isn't too surprising is for the same reason that the "Dogs of the Dow" theory has been a reasonably reliable strategy. In general, if you invest in a company that isn't likely to disappear in the near future or go bankrupt, there's a very good chance that it will rebound strongly after a period of abysmal performance. Decent companies tend not to stay at depressed levels if the market around them is healthy. There are obviously exceptions to that generality, but how many stocks don't display regular ups and downs in the charts, even to the point of periodic extremes?
Having looked, over about 30 years of investing results, very few "losers" failed to redeem themselves. That may be due in part to serendipity, but also from shunning really speculative issues. Back in the days when I had a stock broker, and I really did like and respect him, it was actually maddening to see how frequently stocks that had been sold for a loss had recovered. Given the choice between taking a tax credit or a stock loss or paying more taxes because of greater gains, I would take the latter every time.
However, my broker was a firm believer in taking losses if they hit the 10% level, which is a very traditional approach. To his credit, he followed his rules and was consistent in his application of those rules.
Consistency is what is ultimately one of the most important things when managing investments, even though there may be other paths to the same destination.
What I had also noticed was that there was no guarantee that the proceeds from the sale of losers past would then be recycled into shares of winners. Sometimes losers begat losers and sometimes losers begat winners. To a large degree the direction of the overall market was a factor in where individual stocks would go, especially if looking at an entire portfolio. However, even beautifully woven theses didn't always go as envisioned and occasionally losses mounted, even though the intentions were honorable, but restricted by protocol.
In hindsight I always believe that when holding a loser I should have followed that 10% rule, but then you realize that the real dynamic at play is deciding whether to follow your humble or arrogant side into battle.
The arrogant side believes that it can take the money from the sale of a loser, re-invest it and recover the losses. The humble side wonders how it could be that someone so stupid as to have made the original investment in the first place and then watch it go down so much, could now possibly be smart enough to immediately pick a winner, instead of doing the same thing all over again.
For me, it's hard not to take the humble side's argument. Logic prevails in that argument over blind hope.
So where to begin?
Assuming that you are in the highest Federal tax brackets in 2013, the short term tax rate is 39.6%, although the rate will vary from 10 to 39.6% and doesn't include state tax rates, if any.
As always, your losses are limited to $3,000 in excess of your reported gains, with the ability to carry over additional losses to subsequent tax years. I'm desperately hoping that no one is reporting net losses, but rather looking to reduce their taxable liability.
That means that selling a losing stock gives you a credit against your gains, which includes option premium derived income, which is always taxed at the short term rate. If you do a lot of covered option selling you then may very well have a need or at least a desire to see whether there are any steps that can be taken to reduce your tax liability.
To make the decision of whether to take a strategic loss you have to look at the probabilities of various outcomes.
The first is the 100% probability that if taking the loss you will get a credit to your tax liability, subject to Wash Sales Rules. It's hard to beat those odds, but if you do practice the serial kind of buy/write trades, as I often do, you also need to have a very good understanding of the wash sales rule and be very mindful of the 30 day window on either side of your strategic tax loss trade.
The next step takes some calculation.
As an example, I'm going to look at J.C. Penney (JCP) shares that I bought on July 30, 2013 at $16.16 and currently trading at $8.75. These values are not adjusted to reflect any option premiums collected. It doesn't take a mathematics savant to know that is a loss well in excess of 10%. If Bernard Baruch were still alive he would slap me silly, as corporal punishment was still acceptable in his day.
The potential tax related advantage is based upon your tax rate and whether the holding is a short term or long term holding, with a one year period being the dividing line between the two. As a short term holding the JC Penney position is entitled up to a 39.6% credit against capital gains. In this case that credit can be worth up to $2.93 per share.
However, the next step involves the second probability in the equation. What do you believe is the chance that J.C. Penney shares will of their own trading add $2.93 to its current share price. How likely is it that shares will gain 33.5%? There may be company specific challenges, as well as broader economic challenges to consider. But there is also that thought that this could be the year to atone for past performance. Redemption, after all, isn't limited to Hewlett-Packard.
If you believe that may happen within your lifetime or an acceptable portion of that lifetime, you may decide to forego the certainty of a short term tax credit.
Similar considerations may be applied to shares of Petrobras (PBR) and Mosaic (MOS), both of which I'm considering selling for their tax benefits. However, as compared to J.C. Penney, the hurdle for price recovery to match the tax benefit is quite a bit lower, at 18.5% and 11.7%, respectively.
Of course, if you're right, even at that new higher price you can still qualify for a tax loss, however, you may find yourself looking at a much lower credit, if the short term loss becomes a long term loss. As Clint Eastwood might have said, "are you feeling lucky?" If you can grab some option premiums along the way you can help to make your own luck, but whatever the outcome, it is also deferred by a year to 2015, which itself may entail further opportunity costs.
Then again, just look at last year's losers. Unlikely as it may have seemed at the time, recovery wasn't outside the realm of possibility.
Bottom line? Ask your tax advisor, but do so soon.
Additional disclosure: I may sell shares of JCP, MOS and/or PBR prior to January 1, 2014