- The tax-smart value of a municipal bond portfolio takes into account the after-tax sale price and hold value.
- When deciding whether to sell a bond or continue holding it, two strategies to consider are selling and reinvesting, or doing nothing.
- The tax-smart performance of these strategies can vary based on market price movements.
- If the price increases, selling and reinvesting may result in greater returns due to the opportunity cost of not recognizing a capital loss.
- If the price decreases, the performance of the tax-loss selling strategy may still be slightly better due to factors such as interest income from reinvestment.
- Selling and reinvesting a bond loss also restarts the short-term clock, allowing for higher tax savings if there are offsetting short-term gains.
- Tax-smart portfolio valuation can help identify opportunities to improve after-tax performance by recognizing losses.
In “The True Value of Your Muni Portfolio,” the tax-smart value of a taxable portfolio was introduced as a better measure than market value. This value takes into account the after-tax sale price and hold value of a security. Taking this concept further, this article considers the decision-making process when deciding whether to sell a municipal bond or continue holding it.
To illustrate this, let’s consider a 10-year 5% bond that was purchased two years ago for 113.3 and currently has a tax basis of 111. The current market price is 106, resulting in a long-term capital loss of 5 points. At a 20% tax rate, this loss would lead to a 1-point tax saving, resulting in after-tax proceeds of 107. Comparing this to the hold value of 106, it is clear that the tax-smart value is 107.
Now, the question arises: should you sell the bond at 106 and realize the 5-point loss, or should you continue holding it? There are two investment strategies to consider: sell and reinvest or do nothing. In the sell and reinvest strategy, the after-tax proceeds from the sale are reinvested in a like 5% 8-year bond, effectively increasing the par amount of your holding.
To evaluate the tax-smart performance of these strategies, let’s consider two scenarios: the price rises to 110 or drops to 102 in the following year. The tax-smart portfolio values corresponding to these strategies are shown in the accompanying tables. It is important to note that the tax basis depends on the chosen strategy. Under the do-nothing strategy, the tax basis is based on the original purchase price of 113.3, resulting in a tax basis of 109.782. Under the sell and repurchase at 106 strategy, the tax basis is 105.352, and the notional amount of the investment has increased by a factor of 107/106.
In scenario 1, where the price rises to 110, the tax-smart return based on the sell and reinvest strategy is 8.414%, while the return based on the do-nothing strategy is 7.426%. The roughly 1% difference is due to the opportunity cost of not recognizing the capital loss, which may be lost forever once the price increases.
In scenario 2, where the price falls to 102, the tax-loss selling strategy still performs slightly better with a return of 1.589% compared to 1.466% for the do-nothing strategy. This difference is partly attributable to the greater interest income from reinvestment under the tax-loss selling strategy and the amortization of the basis corresponding to different purchase prices.
Furthermore, selling and reinvesting a bond loss has an additional benefit. It restarts the short-term clock, allowing for the recognition of short-term losses at a higher effective tax rate if there are offsetting short-term gains. For example, if the market price declines to 102, resulting in a loss of 3.384, the tax savings would be 1.354 at a 40% tax rate. This would increase the tax-smart terminal value to 104.316 and improve the return to 2.223%, compared to 1.589% for the tax-loss selling strategy.
In summary, a tax-smart portfolio valuation can highlight opportunities to improve after-tax performance by recognizing losses. It identifies selling opportunities by comparing after-tax proceeds from sale to hold value. Selling and reinvesting a bond loss can be particularly effective if the price subsequently improves due to the opportunity cost associated with staying idle. Furthermore, if the price subsequently declines, restarting the short-term clock provides an opportunity to recognize short-term losses at a higher effective tax rate, further improving performance compared to doing nothing.
