Dodging Taxes: Hold Garmin, McDonald's, And Visa - Then Sell

Includes: GRMN, MCD, V
by: Andrew Noland

I am no David Einhorn, but I was fortunate to have one of my stocks make a run recently: Garmin (NASDAQ:GRMN) rose to $48 because of strong earnings, giving me a nice return from my purchase price of $33 in May 2011.

If you bought McDonald's (NYSE:MCD) or Visa (NYSE:V) in May, you are in the same boat that I am:

Stock Garmin McDonald's Visa
Price on May 2 '11 $34 $78 $79
Price today $48 $101 $117
Percent return 41% 42% 48%

My initial reaction when Garmin hit $48 was to sell and reallocate the capital to another undervalued stock. But then I decided to channel my inner-Mitt Romney and research the capital gains tax laws before pulling the trigger on the sale. Capital gains are taxed at your regular income tax rate if the shares were held one year or less, but at a lower, special rate if they were held over a year.

By holding three months longer to reach the twelve-month plateau, an investor's tax burden on selling the stock declines. The following table demonstrates this for the 15% and the 33% tax brackets, assuming 1% transaction costs and share purchases at the May 2, 2011 price listed in the table above:

Actual returns after short-term capital gains tax

Share price today GRMN: $48 MCD: $101 V: $117
Tax bracket 15% 33% 15% 33% 15% 33%
$ Realized per share 45.49 43.06 96.69 92.73 110.30 103.67

Actual returns after long-term capital gains tax

Price May 3 '12 GRMN: $48 MCD: $101 V: $117
Tax bracket 15% 33% 15% 33% 15% 33%
$ Realized per share 47.52 45.49 99.99 96.69 115.83 110.30

You can see that by holding the stock for a year, you are essentially paid a bonus by the government. Not bad. Of course, you are taking the risk that the stock might go down beyond the tax benefit, but then it also might go up.

Some clever investors may want to have their cake and eat it too: by shorting about three-fourths of his or her current holdings, an investor nearly can lock in the current price and wait to sell when the long-term capital gains rate hits, then cover the short for a smaller short-term gain or loss and pay fewer taxes as a whole. But the IRS does not allow this practice, with a prohibition against "wash sale" trades designed to turn maximize short-term losses and long-term gains. Wash sale rules prevent you from using tax losses on stocks you are short and long at the same time, or that you sell and re-buy within 30 days. For more info on wash sale rules, click here.

Here's a tax tactic that the IRS does allow: Say you bought one lot of shares in May and another in November. You want to minimize your taxes, but you also want to get rid of your shares as soon as you can. You can tell your broker or the trading web site you use to alter the cost basis calculation from first in, first out (FIFO) to last in, first out (LIFO). Then sell your November shares today. You will be taxed at the short-term rate for those shares. But you can sell your remaining shares in May to get the long-term capital gains rate on that lot and exit the position. Be sure that you do not employ dividend reinvestment on your shares, because that may cause the wash sale rule to kick in.

Even if you are a buy-and-hold kind of guy/gal not concerned about tax management, one quick tip: You may want to sell around October 2012. That's because the capital gains taxes for 2013 are increasing. This is an incentive for investors and fund managers to sell in late 2012 and capture gains while the tax rate is still low. In turn, those gains will prompt investors to sell their losing stocks as well to realize capital losses that further minimize the current tax burden. A Graham-and-Doddsville investor may choose to ride the wave, but someone who likes to play the market's ups and downs may want to consider selling shares before November '12 and jumping back in by late December.

Disclaimer: I am not a CPA. This is an opinion based on research. There could be wrinkles in the tax laws that my research did not reveal. I advise you to talk to an accountant about your specific tax situation before you wholeheartedly rely on this advice.

Disclosure: I am long GRMN.