Taking Lemons and Making Lemonade

Rick Foytek, MBA, CFA
Managing Director
cpi@creativeplanning.com

One of the primary goals of investing is to buy low, and then sell high.  While simple in theory, this goal is often far more elusive than many investors believe.  Once investors have a few bear markets under their belt, they understand just how difficult it is to actually dispose of an investment at a higher price than what was paid.  On the other hand, they begin to see how easy it is to do the opposite.  While buying low and selling high is a way to become a profitable investor, a few investment mistakes are not the end of the world.  In fact, these mistakes have their own amount of unique utility.

When we sell an investment at a price higher than our original purchase price, our profit is referred to as a capital gain.  This capital gain is treated as a taxable event1, and is taxed at one of two rates.  If this gain was incurred after holding the investment for less than one year, it is deemed to be a short-term gain, and is taxed at the investor’s ordinary income tax rate.  If however, this gain was the result of selling an investment after a holding period greater than a year, it is deemed a long-term capital gain.  Long-term capital gains are taxed at their own special rate, currently 15% for most investors.  However, for those investors who sell an investment at a price lower than their original purchase price, their loss is referred to as a capital loss.  In a strange display of mercy, the IRS allows you to cushion some of the financial pain of incurring capital losses.  In fact, they offer two kinds of relief; a full offset to capital gains and/or a partial offset to ordinary income.

Let’s cover the capital gains offset first.  The IRS allows investors the ability to fully offset capital gains with any capital losses, dollar for dollar.  For example, suppose you sold some of your winners for a total capital gain of $10,000.  If these were your only transactions, you would be on the hook for the tax bill, which would be at least $1,500.  If however, you had also sold some of your investment losers for a total capital loss of $10,000, the losses would completely neutralize the gains.  As a result, no taxes would be due.  The IRS even thought about the unlucky investors who had capital losses that exceeded their gains.  In this case, the investor is allowed to carry forward these unused losses to offset both future gains and/or ordinary income.

Using the previous example let’s pretend that you had losses that instead totaled $20,000.  In this case, you would be allowed to carry forward the surplus $10,000 in losses to offset future capital gains until they are used up.  As another example please see the table below.  In this example you would be fully covered in years one and two, and partially covered in year three:

*assumes 15% long-term capital gains rate

In addition to capital losses being available to offset capital gains, losses are also available to offset as much as $3,000/year in ordinary income.  Ordinary income can be offset in conjunction with or separate from capital gains.  For example, if we continue our previous example, your $20,000 loss would only cover years one and two:

*assumes 15% long-term capital gains rate

While the above analysis shows that utilizing capital losses can help take the sting out of these mistakes, we will now show you how to take these lemons and make lemonade.  In other words, if we have a losing investment, we can strategically use them to our advantage.  More specifically, we can intentionally realize losses to build up a tax benefit.  For example, let’s pretend that you invested $100,000 in the Vanguard 500 Index Fund on the first day of 2008.   Given the market’s downdraft that year, your $100,000 position would have been worth just $63,000 at the end of 2008.  Since this Vanguard Fund attempts to follow the S&P 500 Index, its $37,000 loss is due to overall weakness in the stock market.  While the reason for the market’s weakness may still be unclear, it is very clear that you now have a $63,000 investment in an index fund that follows the S&P 500.

If you were to execute a tax-loss sale, you would sell your Vanguard 500 fund, realize the $37,000 loss, and immediately invest all $63,000 into a similar (but not identical2) index fund.  For example, you could establish a $63,000 position in a nearly identical Schwab US Large Cap Stock Index ETF.  While you have clearly changed your holdings, your portfolio is essentially unchanged.  Why?  Because you still have $63,000 in an index fund that owns almost the same stocks.  However, now you have the $37,000 loss that can be used exactly the same way as our previous examples.  While some investors may choose to wait it out and hope that the Vanguard Fund gains nearly 59%3 to get back to $100,0004, they are missing a golden opportunity.  You could also however, choose to sell the Vanguard Fund, book the loss, and buy the same fund back.  You must be careful, as the IRS will disallow the loss if you buy back the identical fund back within 30 days.  This short-term buy back is called a “wash sale”, and would invalidate the $37,000 loss.  In addition, you would be taking the chance that the Vanguard Fund could quickly recover during those 30 days.  If that were to happen, you would not have been able to participate in the price improvement.  We would argue that maintaining the $63,000 position in a similar index fund is much wiser.

While we would argue that tax-loss selling works best with mutual funds or ETFs, they can sometimes be executed with individual stock positions.  The problem is that there are many differences between individual stocks.  For example, what would you use as a replacement stock for Ford, Home Depot, or CVS?  Even though many would shout out General Motors, Lowe’s, and Walgreen, they are not close enough to result in an investment-neutral trade for your portfolio. Individual stocks within the same industry can move in very different directions.  In other words, being in the same industry or category does not guarantee you that two stocks will have identical performance results.  To properly execute a tax loss sale that has the least performance impact to a portfolio, it is best to sell a mutual fund or ETF that covers a larger area of the market and replace with one that also covers a substantially similar area.  You could also use this method to increase diversification.

For example, if you sold your positions in Apple, Google, and Microsoft at losses, you could invest the total proceeds in a sector-focused Exchange Traded Fund such as an ETF that follows the Technology sector.  Again, you would have maintained your absolute dollar position in the Tech sector, increased your diversification by reducing company-specific risk, but you would now have use of the realized losses.

Even though these strategies are only applicable for taxable portfolios, they can essentially turn them into tax-free portfolios for a period of time.  Said differently, if you were to build up these tax-loss benefits, you would be able to ignore future gains just like you would in an IRA.  Opportunistic investors had golden opportunity in the midst of the financial meltdown of 2008 and early 2009.  During these volatile months, investors could have easily harvested tax losses several times.  From that point on, they would have a built-in tax benefit that could alleviate some of the pitfalls of a taxable portfolio: mutual fund capital gains distributions, proactive portfolio rebalancing, and/or unplanned cash needs or corporate actions5.  Ignoring the effects of taxes when considering a rebalancing program can be very helpful as well.  This comes into play when investors hold off on otherwise worthwhile rebalancing trades solely due to the tax consequences.  As successful investors know, you should never let the tax tail wag the investment dog.  However, thoughtful tax-loss strategies can allow you to take lemons and make lemonade.

Assumes investments are held in a fully taxable account.  Investments in qualified accounts are not subject to taxes on capital gains.

While the IRS can sometimes show mercy and give an inch, don’t even try to push for a mile.

It will take a 59% gain to claw back to break-even ($100,000) given the now lower starting point.

While this investor is missing a golden opportunity, this is still far superior to simply selling it and then trying to time the market if/when they get back in.

While investors may not plan on taking money out of their taxable portfolios and/or their decades-old stock to be sold out from under them due to a merger, life has a way of laughing at our plans.

This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.