Unlike 2012, when looming changes to capital gains and other taxes sent owners of assets from stocks to real estate and caused a mini-year-end selling frenzy to lock in gains at lower rates, 2013 provides no such overt catalyst. But with the year drawing to a close, it is still the time investors need to look at their portfolios for rebalancing and determining asset allocation. While it should never be the driver of investment decisions, one needs to always keep an eye on tax implications as they can have a significant impact on final total returns.
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Typically at year end, you'll see some profit taking in winners to reduce exposure in names that have become a much larger percentage of the portfolio through price appreciation. This is often accompanied by the selling of losers, sometimes simply because the investment was deemed 'wrong" but often because selling losers is driven by tax decisions. This is known as tax-loss selling, in which the losses from one investment can be used to offset the gains in another. This may be especially important this year as so many stocks have substantial gains.
But the Wash-sale Rule states in order for the loss to be allowed one cannot purchase a "substantially identical stock or security" within 30 days of the sale. This makes some people reluctant to sell out losers in which they have a strong and long held conviction based on the fear that they will miss a turning point.
Think turnaround stories such as Best Buy (BBY). If you had dumped shares in late December of 2012 after the stock had plunged some 70% that year and then waited until the third week of January to repurchase, you would have missed that first 50% gain and may have never gotten back in. The shares are now up an additional 190% this year. Some people may be thinking the same way about J.C. Penny (JCP). And I think we know how gold bugs feel.
Options may provide a way to bridge that 30-day divide and work around the "substantially identical" clause to keep some upside exposure while benefitting from the tax loss selling. But before I go any further, let me state a huge caveat. Tax laws surrounding Wash-sales can be extremely complicated and one should consult with a financial planner and certified accountant, of which I am neither, before engaging in any transactions.
Similar But Not the Same
There is still some debate over what constitutes "substantially identical," but most of it boils down to this: Does the new position essentially track the risk and profit-and-loss profile of the old position? A basic replacement strategy in which stock is sold and long-term, in-the-money calls are purchased would probably be disallowed. Buying short-term, out-of-the-money calls or a spread that has a much lower delta and a limited profit are usually deemed sufficiently different to pass muster.
A safer route would be to make use of the plethora of exchange traded funds that have become available since the Wash-sale Rule came into effect.
For example, this past year, commodity-based stocks Cliffs Natural Resources (CLF), Arch Coal (ACI), and Potash (POT), and the related equipment makers like Caterpillar (CAT) are off 15-to-30% this year. One could consider selling the shares and buying an ETF such as SPDR Metals & Mining (XME) and SPDR Materials (XLB). Given that the beta of the ETFs are lower than individual holdings, one could use call options to increase the leverage, so if the sector does turn, the position will enjoy the commensurate benefits. Once the 30-day waiting period is over, you can switch back into individual names.
In more narrow sectors, such as gold in which the correlation between individual names and ETFs is much tighter, the strategy is even more attractive. So, switching from miners like Newmont (NEM) and GoldCorp (GG) to SPDR Gold Trust (GLD) or vice versa, all of which are down over 25% this year, will give you the benefit of the tax loss sale while maintaining upside exposure.
Finally, let's look at ways to time shift a holding. For a long time, people wanting to maintain upside exposure but eliminate short-term risk, thereby shifting the higher income tax rate down to a the lower long-term capital gains rate, could do so fairly simply: Initiate a fresh short-sale position, use futures, buy deep-in-the-money puts, or sell deep-in-the-money calls. But in 1997, Congress introduced the Constructive Sale Rule, which disallowed such offsetting transactions. Note that all the rules apply equally to positions that were initiated as shorts in terms of closing out for a profit or a loss.
But there are some there some exceptions that involve holding periods or employing more complicated options strategies that are legitimate on the theory that sufficient risk still exists as not to constitute a constructive sale. These might include employing a collar, which is the simultaneous purchase of an out-of-the-money put and the sale of an out-of-the-money call. This creates a band in which additional profits and losses still can be achieved or incurred but are well defined and limited. But again, check with an appropriate advisor as the rules can be dependent on the risk retained, which includes more than the dollar amount, the percentage range, and the volatility. Some of these issues are still being debated in Congress.
In the meantime, it always pays to explore the ways in which options can help reduce risk and boost returns.