This article reviews tax-loss harvesting and tax-loss swapping concepts from Breckinridge’s portfolio management perspective. This article is not intended to be tax or investment advice. Since tax and financial situations can differ from one individual to the next, it is always advisable to consult with a tax professional or refer to the latest Internal Revenue Service guidelines to better understand how specific rules apply to individual circumstances.

Tax-Loss Strategies Can Lower Tax Liabilities

In bond investing, tax-loss harvesting involves selling one or more bonds in which an investor has unrealized capital losses and using those harvested losses to offset capital gains. If there are remaining losses after offsetting gains (in other words, net losses), an investor may also apply the losses to offset up to $3,000 of ordinary income in a year (or $1,500 for married individuals filing separately).¹

Investors may also be allowed to carry forward for tax purposes in future years additional net losses above this limit. Figure 1 illustrates a simple one-for-one investment example of how a realized loss may help reduce a tax liability for an investor.

With the goal of remaining fully invested in the market, proceeds from a sale are typically reinvested into another bond.

When reinvesting, it may make sense to strategically adjust portfolio holdings. In the example illustrated in Figure 1, an investor seeking to increase current income might use the sale proceeds to purchase bonds with higher coupons or to extend or shorten the maturity range of his or her bond portfolio.

Is there a difference between Tax-Loss Harvesting and Tax-Loss Crossing?

Tax-loss crossing is a form of tax-loss harvesting done concurrently between two separate investors. In a tax-loss cross trade, an investor sells a bond for which the market value has fallen below the purchase price, realizing the capital loss, and simultaneously buys a similar but not identical bond from a different investor. Cross trades may result in lower transaction costs than trading on the open market, and keep the assets invested while preserving overall structure and the investment strategy of the investment portfolio. 

When Breckinridge conducts tax-loss crossing, we seek to purchase investments with some combination of similar maturity, quality, and coupon characteristics as the sold security. Our goal is to take part in the tax advantages of specific bonds while minimizing changes to the overall portfolio’s integrity.

Be Prepared to Take Advantage of Opportunities 

As interest rates rise, bonds will often incur unrealized capital losses. As 2022 illustrated, the speed and magnitude of rate increases can result in sizeable losses even for bonds that have high quality credit ratings. This is particularly true if interest rates are at absolute low levels preceding an upward shift in rates. 

While conditions in 2022 and thus far in 2023 have offered bond managers the ability to harvest losses, some investors may only think of, or execute on, tax-loss harvesting initiatives toward the end of the calendar year. 

History has shown bond price declines due to increases in interest rates can happen throughout the year. As shown in Figure 2, using the broad Bloomberg Municipal Bond Index benchmark, we can see that it is often the case that the largest monthly losses may happen during earlier months of the year. Those losses may be reduced or potentially fully reversed by year end, thereby potentially eliminating the ability to capture a tax advantage, investing at higher average yields, and/or improving portfolio structure. 

Avoid Wash Sales 

A critical point in tax-loss harvesting and tax-loss swapping is to avoid wash sales. A wash sale occurs when an investor sells a bond and, within 30 days before or after the sale, purchases the same or a nearly identical bond as the one sold. 

In the event of a wash sale, an investor is not allowed to use the loss on the sale to offset capital gains or to reduce taxable income. Investors can seek to purchase bonds that have characteristics—including issuers, maturities, or coupons—that differ from the bond sold.

Tax Loss Harvesting Can Help Manage Tax Liabilities

During periods when interest rates change or when tax policy changes, tax-loss harvesting strategies can offer opportunities to manage overall tax liabilities for individual investors. Breckinridge employs tax-loss management strategies in its tax-efficient strategies, as market conditions warrant. Through our attentive approach, we seek to assess tax-loss opportunities throughout the year.

#BCAI-06292023-uu3r0ysl (July 5, 2023)

[1] Based on 2023 federal tax guidelines, which are subject to change.

[2] Per Bankrate.com, for tax year 2023, the long-term capital gains tax rate for individual tax filers earning between $44,626 to $492,300 and tax filers filing jointly earning between $89,251 to $553,850 is 15 percent. The long-term capital gains tax rate for individual tax filers earning more than $492,300 and tax filers filing jointly earning more than $553,850 is 20 percent.

[3] For tax year 2023, the top tax rate is 37% for individual single taxpayers with incomes greater than $578,125 ($693,750 for married couples filing jointly).

DISCLAIMER:

This material provides general information and should not be construed as a solicitation or offer of Breckinridge services or products or as legal, tax or investment advice. The content is current as of the time of writing or as designated within the material. All information, including the opinions and views of Breckinridge, is subject to change without notice.

Past performance is not a guarantee of future results. Breckinridge makes no assurances, warranties or representations that any strategies described herein will meet their investment objectives or incur any profits. Any index results shown are for illustrative purposes and do not represent the performance of any specific investment. Indices are unmanaged and investors cannot directly invest in them. They do not reflect any management, custody, transaction or other expenses, and generally assume reinvestment of dividends, income and capital gains. Performance of indices may be more or less volatile than any investment strategy.

All investments involve risk, including loss of principal. Diversification cannot assure a profit or protect against loss. Fixed income investments have varying degrees of credit risk, interest rate risk, default risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Income from municipal bonds can be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the IRS or state tax authorities, or noncompliant conduct of a bond issuer.

The effectiveness of any tax management strategy is largely dependent on each investor’s entire tax and investment profile, including investments made outside of Breckinridge’s advisory services. As such, there is a risk that the strategy used to reduce the tax liability of the investor is not the most effective for that investor. Breckinridge is not a tax advisor and does not provide personal tax advice. The tax consequences of Breckinridge’s tax loss strategies may be challenged by the IRS. Investors should consult with their tax professionals regarding tax strategies and associated consequences.

Tax laws and regulations are complex and subject to change at any time. These changes can impact tax consequences and investment results for investors, who should consult with a tax professional before making any decisions.

Tax loss harvesting may generate a higher number of trades in an account due to our attempt to capture losses. This can mean higher overall transaction costs to clients. To the extent that a client's custodian uses a different pricing source, cost basis or tax lot accounting, actual tax efficiencies could be greater or lower than what has been shown. Also, a client may repurchase a bond at a higher or lower price than the price at which the original bond was sold. The replacement bond is subject to price fluctuations.

Federal and local tax laws and rates can change at any time; changes to tax laws and rates can impact tax consequences for investors. Further, the Internal Revenue Service (IRS) and other taxing authorities have set certain limitations and restrictions on tax loss harvesting. The tax consequences of Breckinridge’s tax loss strategy may be challenged by the IRS. Investors should consult with their tax professionals regarding tax loss harvesting strategies and associated consequences.

Cross transactions will be used to facilitate tax loss harvesting in most cases. When using cross transactions for tax loss harvesting, participating client accounts gain exposure to the tax-loss harvested bonds received from other accounts. While Breckinridge generally selects bonds that, in its best judgement, will not change significantly in price, bonds nevertheless are subject to fluctuations in price, and the bonds received may go up or down in value.

Cross trades create a conflict as the adviser is advising clients on both sides of the transaction. Also, cross trades can result in more favorable treatment to one client over the other. There is no guarantee that the buying or selling client will receive the best prices available for the day. Breckinridge investors can opt out of tax loss harvesting and/or cross trading. In cases where an investor opts out of or is prohibited from cross trading, they may not receive the benefit of lower transaction costs versus trading in the open market and the same price as those investors participating in cross trades.

Separate accounts may not be suitable for all investors.

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