Investors and their advisers have weathered several years of turmoil, with market conditions often upending conventional investing approaches and related tax strategies. As recently as summer 2010, Federal Reserve Board Chairman Ben Bernanke testified before Congress that the outlook for the U.S. economy remained “unusually uncertain.” Slightly more than a year later, on Aug. 8, 2011, evidence of continued economic uncertainty was strongly reinforced as the Chicago Board Options Exchange Volatility Index (VIX), sometimes referred to as the “fear gauge,” jumped to a 29-month high.
While an “unusually uncertain” economic outlook creates significant challenges for advisers and their clients, it also provides opportunities to implement tax-advantaged investment strategies that may mitigate risk and/or enhance after-tax returns. Seven such strategies are presented here. Depending on their clients’ situations, advisers may wish to employ one or more of them.
Qualified covered calls
Taxpayers who have substantial, currently nondeductible capital losses and who seek to generate offsetting gains may benefit from a strategy of writing covered calls. In a covered call, the investor owns the underlying shares for which he or she writes the call. A qualified covered call is one that is exchange-traded, has at least 30 days remaining until expiration, and has a strike price that is not considered too far “in the money” (i.e., it generally cannot be lower than the first strike price below the closing price on the most recent trading day before the option was granted). In addition, gain or loss on the option must not be ordinary income or loss, and the option must not be granted by an options dealer in connection with an activity of dealing in options. See Sec. 1092(c)(4).
Example 1. A owns 1,000 shares of Z Corp. that he purchased several years ago for $45 per share and that are now trading at $50 per share. He also has $30,000 in currently unusable excess capital losses. He writes (sells) options at a price of $3 per share guaranteeing the purchaser the right to buy his shares in Z Corp. at $65 per share for the next 60 days. If the stock’s price does not rise above $65, the call will expire unused (i.e., the stock is not sold), and A will realize a short-term capital gain of $3,000 (1,000 shares × $3 per share option price). If the price rises above $65, A will sell the shares and recognize a long-term capital gain of at least $23,000 ([1,000 shares × ($65 per share selling price + $3 per share option price)] − [1,000 shares × $45 per share purchase price]). In either case, he generates capital gain income that can be fully offset against otherwise currently unusable capital losses.
As an investment strategy, writing covered calls has been found to generate superior risk-related returns, at least with respect to the Standard & Poor’s 500 Index. The broad rationale for its success, according to an article in The Wall Street Journal, is that “[c]all options are usually overpriced,” with the result that they are usually more profitable to sellers than buyers (“Buy-Write: Safe Harbor in Troubled Times,” by Brett Arends, April 20, 2009). The limitation of a covered call strategy is that it caps upside gain and therefore may not be suitable for more-aggressive investors.
Private activity bonds
Investing in private activity bonds may provide taxpayers not subject to the alternative minimum tax (AMT)—and even taxpayers at higher marginal rates that are subject to the AMT—with the benefit of an “uncertainty” premium. Taxpayers in a high marginal tax bracket but not subject to the AMT may benefit most from high yield spreads between AMT-free and AMT-subject municipal bonds. The yield spreads, according to a recent study, reflect a return beyond the premium attributable to tax effects between paired AMT-free and AMT-subject municipal bonds (see, “Yield Spreads on Municipal Bonds Subject to the Alternative Minimum Tax,” by Ginette McManus, Rajneesh Sharma, and Ahmet Tezel, Journal of Taxation of Investments, Vol. 28 (4), page 21 (Summer 2011)). Total average yield spreads between AMT-free and AMT-subject bonds were found, for a specified period of the study, to be 1.75%, resulting in average implicit marginal tax rates of 38.77%, well above the highest marginal AMT rate applicable for individuals, 28%. In some states, such as Tennessee, the implicit marginal tax rate was more than 50%.
The researchers, using Bloomberg data, matched AMT-free and AMT bonds by state, coupon rate, remaining years to maturity, insurance status, and ratings for the period April 9, 2009, through April 21, 2009. The period during which this data was collected may be viewed as one of heightened economic uncertainty, as it shortly followed the bottoming of the stock market on March 9, 2009. Accordingly, such findings may suggest that, during periods of heightened economic uncertainty, taxpayers in high marginal income brackets who are confident that they will not be subject to the AMT may be able to achieve enhanced after-tax returns by investing, for similarly creditworthy issues, in private activity bonds. In some cases, even taxpayers subject to the AMT may achieve higher after-tax returns by investing in AMT-subject bonds, rather than in AMT-free municipal bonds.
Example 2. B, a resident of Tennessee subject to the AMT, purchases two $100,000 municipal bonds, one subject to the AMT and one AMT free. The AMT-subject bond pays 4.83% interest, for a before-tax return of $4,830 ($100,000 × 4.83%). AMT is $1,352 ($4,830 × 28%), making the after-tax return $3,478 ($4,830 − $1,352). The AMT-free bond pays 2.36% interest, for a before- and after-tax return of $2,360 ($100,000 × 2.36%). The net after-tax advantage of the AMT-subject bond is $1,118 ($3,478 − $2,360).
As with any municipal bond evaluation, taxpayers and their advisers must consider state taxes, an add-back for the AMT. Also, advisers should be careful to “do the math” for each set of matched computations. The example used here, with the Tennessee bonds, had the highest spread for the 50 states and the District of Columbia. Alternatively, if the matched sets for Minnesota had been used, the state with the lowest yield spread at 26.17%, it would not have been advantageous for a taxpayer subject to the AMT to purchase a bond subject to AMT.
Avoid capital losses on bond holdings
In a low-interest-rate environment, active asset allocation and selection may protect against increased exposure to potentially currently nondeductible capital losses. Such an environment increases bondholders’ exposure to capital losses, which for taxpayers who have excess capital losses may be currently nondeductible. The risk for holders of bonds in a taxable account in such an environment is that an extreme asymmetry is created between the opportunities to achieve capital gains vs. capital losses, with the likelihood becoming far more skewed toward incurring capital losses. Bondholders in such an environment may reduce this risk through asset allocation and selection.
For an extended period, including the 40 years ending April 2009, bonds performed comparably to stocks (S&P 500 compound annual return, 8.70%; SBBI Intermediate-Term Government Bond Index, 8.08%; and the SBBI Long-Term Government Bond Index, 8.79%), with significantly lower risk. This performance, however, was achieved largely because of the capital gains attributable to an initial high-yield environment and the subsequent decline in interest rates.
During a period of economic uncertainty, some investors, seeking what they perceive to be a safer allocation for their investment portfolios, may choose to decrease their equity holdings and increase their bond holdings. Acquiring bonds during a period of low market interest rates, however, creates the skewed probability of their generating more capital losses than capital gains. With market interest rates already well below historical norms, there may be little opportunity to generate capital gains from further interest rate declines. For example, the maximum possible decline for market rates from a current 3% is theoretically 3%, although from a practical perspective it is highly unlikely to be that great.
To mitigate against the risk of generating capital losses from potential increases in market interest rates:
- Where possible, reallocate bond investments into tax-deferred (such as 401(k)) or tax-exempt (such as Roth IRA) accounts and stock investments into taxable accounts. While stocks, of course, may also decline in value, there would not be a skewed asymmetry toward incurring capital losses.
- Purchase individual bonds that will be held until maturity and, therefore, even if interest rates increase, will not generate capital losses. A risk, however, associated with purchasing individual bonds, as opposed to through a mutual fund, is that it may not be possible to achieve sufficient market diversification.
- Purchase bonds that are lower than the highest grade to create a more balanced opportunity to achieve capital gains, as opposed to capital losses. While bonds of all classes will likely decline in value when market interest rates increase, less-than-top-grade bonds may increase in value and generate capital gains if the issuer’s credit rating increases. A top-grade bond provides no opportunity to benefit from a credit upgrade.
- As an alternative to bonds, invest in lower-risk equity exchange-traded fund (ETF) sectors and/or mutual funds. ETFs or mutual funds that invest in consumer household products, for example, may generate lower risk (beta) than, for example, those that invest in riskier sectors, such as transportation issues. Such equity investments, nonetheless, may still hold higher risk than more conservative fixed-income investments.
Avoid short-trading ETFs
More investors may seek to profit by and/or protect against market downturns and volatility by implementing short-sale strategies. Investors considering short-trading ETFs, however, should be advised that the key tax benefit of many ETFs—extremely low turnover—may not apply to some short-trading ETFs. Many ETFs have little or no passthrough of capital gains, such as the SPDR S&P 500 (SPY), which has not had a distribution of capital gains since December 1996. Some short ETFs, on the other hand, have paid out short-term capital gain distributions as high as 7% of assets (see “When ETFs Aren’t Tax-Efficient,” by Scott Burns, Morningstar ETFInvestor, Oct. 1, 2008). The reason is that short ETFs’ assets, rather than being tracked on a benchmark index that require no or minimal sales for redemptions, are kept in pools of cash and custom swap agreements. During periods of net redemptions, short ETFs may have to sell the underlying derivative asset.
Invest in closed-end mutual funds with built-in capital losses
Some mutual funds have incurred excess capital losses, creating opportunities for new investors to defer future capital gain recognition. Regulated investment companies cannot currently deduct capital losses in excess of capital gains and instead must carry forward excess capital losses, even if fund ownership changes. Closed-end funds, which are unable to dilute their built-in losses by issuing new shares, offer greater opportunity to investors to avail themselves of this benefit, offsetting capital gain distributions with these losses.
Example 3. C, an individual, invests in a closed-end mutual fund that has 20 million shares outstanding and capital loss carryforwards of $100 million. C’s benefit at the time of purchase is $5 per share ($100 million ÷ 20 million shares). Even though C invests in the fund after it incurred its losses, she may still benefit by having these prior losses offset against future capital gain income for a maximum of eight years. Further, since the fund is a closed-end fund, C is not at risk of the loss benefit’s being diluted by the fund’s issuing additional shares.
In most cases taxpayers benefit from a deferral rather than an exclusion of income. The income is normally deferred, rather than excluded, because at the time of redemption the investor will not have had a step-up in basis for the previously unrecognized gains. If shares, however, are held until after death, the income will be excluded pursuant to the estate’s tax-free step-up in basis. Deferring capital gains may be especially beneficial for individuals who can do so until the time when they will be subject to a 15% or lower marginal income tax bracket and, therefore, would not be subject to any federal capital gains tax, assuming current law remains in effect.
Opportunities to invest in funds with built-in losses may potentially be greater in those sectors of the economy that have been most adversely affected by the recession and its subsequent aftermath of economic uncertainty. Such sectors may potentially be more represented by cyclical sectors, such as manufacturing, rather than the noncyclical areas such as consumer household products.
Market discount bonds
Some bonds may sell at a market discount because of concerns about the creditworthiness of the issuer and/or concerns other than the current interest rate environment. Such bonds not purchased as original issue discount (OID) bonds can allow taxpayers to significantly defer recognition of interest or other ordinary income.
Y Corp. Bond
Purchase date: Dec. 31, 2011 (purchased in open market, not an OID bond)
Maturity date: Dec. 31, 2016
Face value and purchase price: $10,000 at 85% = $8,500
Coupon yield: 5%
The purchaser of the above bond, per the coupon yield, will receive and recognize $500 (5% × $10,000) in taxable interest income each year from 2012 through 2016. In addition, however, the taxpayer will be able to defer recognition of the entire market discount, $1,500 ($10,000 − $8,500), until the earliest date of when the bond matures or is sold or called. Unlike certificates of deposit, where deferred income is currently taxed, market discount bonds allow income recognition to be deferred until maturity or disposition.
Note that the likelihood that the bond will be called, generating immediate recognition of the deferred ordinary income as well as the call-generated capital gain, is significantly diminished whenever existing market rates are already at low levels, as there is only minimal possible exposure for a further decline in rates. In the event the bond is sold or called prior to maturity, however, the transaction would generate (1) currently taxable ordinary income for the accrued interest (accrued market discount) and (2) capital gain or loss for the difference between the selling price and the purchase price plus interest accrued since the date of purchase. Market discount bonds, similar to those acquired at par or premium, may, nonetheless, increase in value and call risk because of factors other than a change in interest rates, such as an increase in the bond’s rating or an overall increased demand for a newly popular sector of corporate bonds. In either case, however, the investor receives significant after-tax benefits (deferral of market discount interest and/or significant investment income taxed at capital gain rates).
Market discount bonds may prove especially beneficial in retirement planning, where they can defer recognition of income until retirement (when the taxpayer may be in a lower tax bracket). If the bond discount is large, pushing the taxpayer into a higher tax bracket, a more comprehensive strategy may be to sell some bonds prior to maturity but after the taxpayer has retired and is subject to a lower marginal tax rate. This spreads the interest income from the market discount over multiple tax years. A well-structured bond portfolio will have bonds maturing in different years.
However, note restrictions on this treatment of market discount bond income, including that such bonds may not have a maturity date of one year or less from their date of issue (Sec. 1278(a)(1)(B)(i)).
Put options in a Roth conversion or reconversion
Investors may find the conversion/reconversion provisions for Roth IRAs especially beneficial for hedging overall portfolio risk in a tax-advantaged manner. While hedging portfolio risk may be done several ways, such as using an offsetting position and short sales, investors may find that put options in a newly converted Roth IRA provide one practical, efficient, and tax-advantageous way to reduce risk.
Example 5. D, an individual, on Oct. 30, 2012, converts $10,000 in her traditional IRA to a Roth IRA and purchases put options in that amount on a broad stock market index that have two months remaining until expiration. The market index price for the underlying option is currently $100, and the strike price is $86. D also currently holds in a taxable account $1 million in substantially appreciated assets in a diversified portfolio that are generally comparable with, but not substantially identical to, those of the index. D seeks to achieve both limited downside risk protection and a tax benefit through her acquisition of the put options in the Roth account.
Scenario A. As of Dec. 30, 2012, the market index has never declined below $86, and therefore the put options expire as worthless. D reconverts the Roth IRA to a traditional IRA. The $10,000 economic loss fully reduces that amount in the IRA account that, upon distribution or conversion, would otherwise have been taxable as ordinary income.
Scenario B. Before the put options’ expiration, the market declines to 80, and D sells them, realizing a gain of $50,000 ([$86 ‒ $80] × $10,000 = $60,000 gain − $10,000 cost of put). The similar but not substantially identical assets also declined in value by 20%, for a loss of $200,000. The net loss for the transaction, therefore, is $150,000.
Despite the market decline, by using put options D limited her overall portfolio loss to 15% while generating a $50,000 tax-free increase in her Roth account and reducing capital gain exposure in the taxable account by $200,000.
A potential limitation of this strategy is that the cost to purchase put options when they may be most desired, during periods of high economic uncertainty, may be higher than during less volatile times. Accordingly, investors seeking to maintain the viability of such a strategy during especially volatile periods may need to consider alternatives providing lower strike prices and/or shorter durations.
Where a taxpayer who is not acting as a dealer in stock or securities sells stock or securities at a loss and reacquires substantially identical stock or securities within a 61-day window beginning 30 days before the sale and ending 30 days after the sale, no deduction for the loss is allowed under Sec. 165 (Sec. 1091(a); Regs. Sec. 1.1091-1(a)). The loss is disallowed because there has been no change in the taxpayer’s economic position. The wash-sale rules prevent taxpayers from claiming a loss on a stock or security that they still own. They also apply where an option or contract is used to reacquire substantially identical stock or securities. The taxpayer has a wash sale if he or she sells or trades stock or securities at a loss and within 30 days before or after the sale transaction:
- Buys substantially identical stock or securities;
- Acquires substantially identical stock or securities in a fully taxable trade;
- Acquires an option or contract to buy substantially identical stock or securities; or
- Acquires substantially identical stock or securities for the taxpayer’s IRA or Roth IRA.
In all but the fourth instance, the disallowed loss is added to the cost basis of the newly acquired stock or securities (Sec. 1091(d); Regs. Sec. 1.1091-2). This postpones the loss deduction until the new stock or securities are disposed of, and the holding period includes the holding period of the new stock or securities. Where the sale and reacquisition of the stock or security has occurred entirely within an IRA or Roth IRA, the wash-sale rules do not apply. Generally, an IRA is exempt from taxation (Sec. 408(e)(1)). However, where a taxpayer sells shares at a loss outside an IRA and reacquires substantially identical shares within an IRA within the 61-day window, the loss is disallowed under the wash-sale rules, and the basis in the taxpayer’s IRA or Roth IRA is not increased under Sec. 1091(d) (Rev. Rul. 2008-5). Therefore, because of the potential for a permanent loss disallowance, it is especially important that investments in the IRA or Roth IRA not potentially be deemed to be substantially identical shares.
Not all of these strategies may be applicable for all taxpayers, and decisions on implementation may also depend significantly upon nontax factors, such as a taxpayer’s attitude toward risk. Taxpayers with a lower propensity toward risk may, for example, favor writing covered calls but be less comfortable investing in a closed-end fund that has already experienced substantial losses. In all cases, foremost consideration for any selected strategy should be its impact on the overall program of investment.
- Recent periods of high economic uncertainty, while challenging for investors and their advisers, may present opportunities for special tax-advantaged strategies.
- For example, qualified covered calls could generate limited but relatively lesser-risk gains to offset currently nondeductible capital losses.
- Higher marginal rate taxpayers could significantly benefit from the “uncertainty premium” attributable to private activity bonds. In some cases, even taxpayers subject to the alternative minimum tax may realize a higher yield from private activity bonds than from municipal bonds.
- Investments best avoided during periods of uncertainty include short-trading exchange-traded funds, due to their higher asset turnover and redemptions of underlying assets that can generate capital gain distributions to investors.
- Mutual funds with built-in capital losses may be attractive to investors needing to defer gain recognition. In such cases, closed-end funds may offer a more stable option, since they will not dilute losses by issuing new shares. Another vehicle for deferring gain may be market discount bonds.
- Investors may also employ a variety of hedging strategies, involving Roth IRAs and, potentially, their reconversion to a traditional IRA, such as acquiring a put option through a Roth account. However, if a taxpayer sells securities outside an IRA or Roth IRA and reacquires them or substantially identical securities in the account within the wash-sale period, a loss on the sale may be permanently disallowed.
Seth Hammer (firstname.lastname@example.org) is a professor of accounting and Charles J. Russo (email@example.com) is an assistant professor of accounting, both at Towson University in Towson, Md. Hammer is the owner of Tax-Advantaged Retirement and Estate Planning of Maryland, securities and investment advisory services offered through H. Beck Inc. (member FINRA, SIPC). H. Beck Inc. and Tax-Advantaged Retirement and Estate Planning of Maryland are unaffiliated.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at firstname.lastname@example.org or 919-402-4434.
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