Tax swaps are one of the few investment freebies. The concept is pretty simple. You sell an asset in which you have a paper loss. You simultaneously replace it with a similar asset. What you gain is a tax loss to apply to this year's taxes. A tax swap might be particularly relevant to many SA readers as my daily perusal of the site suggests a preponderance of interest in individual stocks which might lend themselves to this strategy.
The General Concept Behind Using Tax Losses
A tax loss is useful if you know you have taken capital gains which you can offset, particularly if they are going to be taxed at a high rate. It is potentially even more useful if you do not have gains to offset, especially if you are in a high bracket for ordinary income. If that is the case, you can apply up to $3000 per return as a straight reduction of ordinary income. You can also retain the amount over $3000 in a "tax loss bank" for future years.
Selling positions meaningfully in the red before the end of the year is an old idea and many investors do it almost automatically on their own initiative, or with a nudge from their brokers. The broker, of course, benefits from the transaction. That doesn't make it a bad idea. In all such calculations, however, whether tax loss selling or swaps, it is important to consider friction from transaction costs.
About this time of year, and sometimes earlier, I go through my taxable portfolio and prune every tranche of every position in which I have a loss. I am particularly aggressive if I already know I have taxable gains. This year, for example, I had some inevitable short term gains from arbitraging the Buffett deal for Precision Castparts (NYSE:PCP) as well as long term gains from cutting some pine trees. I started recently selling every position that had shares in the red. Among the things I sold were recent dividend reinvestment shares of Wells Fargo (NYSE:WFC).
Tax loss "harvesting" may feel like bringing in a bitter crop. It's hard for some people to sell at a loss. I have felt that way myself. Behavioral economics explains it. Selling anything at a loss is an admission of having made a mistake. Here's the difficult thing you have to tell yourself: if you are holding something at a loss, you were wrong - W R O N G. Period. Your mistake is there before your eyes in that day's valuation of your portfolio.
An old and vetted market adage says: sell your losers and let your winners ride. It's anecdotal, but there is some wisdom contained in it.
I know there are two ways of thinking about this. Buffett has said that if you are sure you are right, you shouldn't let a price decline make you sell. You shouldn't let the market tell you what to do. Why should the opinions of others overrule your considered opinion? I have noticed, however, that he sold his large position in Tesco (OTCPK:TSCDF)(OTCPK:TSCDY), and also sold, reconsidered, and bought back Phillips 66 (NYSE:PSX). Few rules are absolute, few gurus are infallible.
You may ultimately be right in your original opinion about a position showing a loss, but you are presently wrong. If you get out of losses somewhere under ten per cent, you generally live to fight another day. I say this even though I am a long term investor, and in recent years have had as few as one or two transactions.
The fact is, you can always revisit a stock you sold after 31 days. If you feel your long term reasons for buying it are still valid and better than alternatives the market is offering, you can buy it again without sacrificing the tax loss. I have done this a few times. I have also sometimes decided that there is a better alternative.
Tax swaps are somewhat more sophisticated than outright sales, and for that reason less common. Around this time of year investment advisors often suggest "bond swaps" to sophisticated and affluent clients. It is suggested mainly for investors who hold individual bonds at a loss. In theory it could also be done with bond funds which do not mimic each other (not index funds, for reasons I will explain later), but this isn't my recommendation. Bond swaps are most commonly done with munis because munis are the type of bond most frequently held in taxable portfolios by affluent investors.
A muni swap might make sense in a year when rates have been rising. The rising rate, being inverse to bond price, will have pushed the bond into the red (so that the rate of return provided by the coupon matches that of newly issued bonds at the current rate). The action would be to sell the old bond and buy a new one of the same or similar duration but a higher coupon. You get the same income. You also get a tax loss. At maturity you get your investment back. The tax loss is a freebie.
Swapping individual bonds is pretty simple. It's too bad, this year, that it's a strategy that mainly works in an environment of rising rates. The recent trend in the bond market has been falling rates and rising bond prices. Very few bond swaps present themselves under present market positions.
What About Tax Swaps With Stocks
The idea of tax swaps with stocks is not as much a standard element of tax planning as tax swaps with bonds. The basic idea of a tax swap involves a pair of transactions which must pass through the eye of a needle. The investments swapped - selling one and buying the other - should be similar enough that you emerge from the swap with essentially the same risk exposure and investment purpose as before. At the same time, they must not be so similar as to be effectively identical from the perspective of the IRS.
This rule is the reason index stock or bond funds cannot be used in a tax swap. Swapping the Vanguard S&P Index Fund for the Fidelity S&P Index Fund would be flagged and disallowed by the IRS as being instruments that are effectively the same thing. It's an individual bond or stock game. And that's what might make it interesting to readers of Seeking Alpha, who are more likely to hold assets that might be swapped to tax advantage.
The downside with stocks, of course, is the very reason that a stock swap would be allowed. No two stocks are exactly alike. The one you bought may have particular virtues. Both certainly have single company risk. Think of Wells Fargo, the premier bank, which turned out to have major and idiosyncratic single company risk. So one should begin by bearing this caveat in mind.
On the other hand, an investment thesis is often applicable to a small group or sector, and one's individual choices may be fairly close to random. This was the case a few months ago when I bought a couple of housing stocks.
Bull And Bear Thesis On Housing, And What I Did
I bought builders in moderate size around the same time I was replacing REITs with banks on a much larger scale (see the mention in this piece here ). The difference in sizing the two positions was pretty simple. I thought banks were a good probability on three time frames - short, intermediate, and long.
I thought builders might be an even better bet long term, but possibly had more short to intermediate hurdles - including not very impressive charts. Like banks - like all cheap stocks - builders had both a bull case and a bear case. Stocks without a bear case I avoid despite the temptations because they are fully priced.
The bull case on builders is that shelter is in short supply, level of resident building is way under trend despite rising volume and prices, and millennials are beginning to resemble their parents more, forming households, making children, and wanting to live in houses. Houses actually have better economics (after taxes) than renting anyway. It isn't even necessary for housing starts to get back to trend. They just have to revert maybe halfway or simply move in the right direction and builders will mint moolah.
The bear case is that builders carry a good bit of debt, are very susceptible to any economic downturn, and tend to speculate stupidly on land bought at the top of the market. All this is true. They are also presently suffering from a shortage of land in inventory and high land prices.
I am pretty confident the bull thesis trounces the bear thesis in the end. The end, however, may be over six or seven years. Over the next year or two the economy could hit a big bump, or things like the cost of land could snag builder profits. Who knows?
Then there was the question of what to buy. I have owned NVR (NYSE:NVR) for a while. I had been thinking about it when I saw a good presentation of the thesis by SA Contributor and Fund Manager Bill Smead. I then did deeper research of my own. I added to my position recently on a dip. I think it's a long term holding, period, unless I see too tempting a tax loss around December 15.
I got my other two ideas from Ivy Zelman, the leading analyst and predictor of the 2008-9 crisis. She had a good view of Lennar (NYSE:LEN) and CalAtlantic (NYSE:CAA). She liked the low end of the market, and from what I have seen at street level with my own eyes this looks like the way to go. Her name cropped up on the recent Lennar earnings call, by the way, querying the problem of high land cost.
I bought Lennar. CalAtlantic, however, was like Robert Frost's road not taken, the passage there having left it nearly about the same. The group then proceeded to go down, NVR, LEN, and CAA with it.
This did not surprise. I had a small position. I had always liked the intermediate to long term more than the short term. Nevertheless, I now had a loss in Lennar large enough to help reduce taxes.
I did the simple and obvious thing. I sold Lennar and within minutes bought an equivalent amount of CAA. They are separate companies serving somewhat different geographic areas, nothing close to identical in IRS terms but similar enough in terms of my investment thesis to be identical. Doing so in two taxable accounts ended up providing about $10,000 of short term tax losses to help offset the Buffett deal while leaving me in pretty much the same position with my basic investment thesis. In fact, the more I think about it the more I think I really liked CalAtlantic better. I do now, anyway. CalAtlantic was prettier once I looked closer. Love the one you're with.
And I had this thought. What if the economy actually sinks or looks enough like it that the builders take another leg down? Hey, I could just sell CalAtlantic, use that tax loss, and simultaneously buy back Lennar, which may start to look prettier again at that moment. Unless at that time something entirely different start to look better. It's a rolling win-win-win, unless of course there is something wrong with my long term thesis, which is entirely possible.
Playing Small Ball And Gaming The World
There is nothing wrong with gaming taxes this way. The code as written allows it - invites it, I'm tempted to say. It's there for you and me to use.
In my last piece, retirement investing (among other things) when you have enough, I mentioned that I had basically made my way through to retirement by playing small ball. It's sort of like Joe Maddon's (does anyone not know he is the Cubs manager? if so, you're like the Japanese soldiers who came in from the woods about 1975) first principle for major league hitting: if the other pitcher wants to throw balls and walk you, let him do it. It's a free pass to first base. Getting to first base is step one of winning ball games. It's just as good as hitting a line drive. Even Kris Bryant does it.
Tax swaps are like that. They are part of the small ball bag of tricks, a way of gaming the world that is based on arithmetic instead of genius or an amazing batting eye. If it makes sense to you, be sure you understand it thoroughly and tuck it away in your own bag of small ball tricks.
Disclosure: I am/we are long CAA, WFC, NVR.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.