How and when to swap securities so you can pin down a tax loss
With its erratic behavior this year, the stock market has produced plenty of losses for investors. Fortunately, there is a way many of these people can offset some of the losses. It's called swapping, and it has become an annual event: In the last quarter of the year, investors look for depressed securities they can sell in order to register a loss, and then they purchase a similar security to maintain their investment position.
In most cases, the swapping is done with municipal bonds. Because ''munis'' are fixed-income investments, it is fairly easy to substitute one type of muni for another, since you can shop for a comparable interest rate. It is possible to do straight stock swaps, but even if the two companies are in the same industry, their stocks may not perform the same way. You can use a swap to offset any kind of loss, however.
''A loss is a loss,'' says Richard Molnar, senior vice-president in the municipal bond department of Prescott, Ball & Turben, a Cleveland brokerage. A swap could be used to offset a loss in a real estate sale, mutual fund shares that had gone down in value before being sold, or a drop in the price of a municipal bond portfolio.
The primary motivation for swapping is cutting taxes, but it should not be the overriding reason. The quality of the municipals being acquired - and the likely market for them in the future - is just as important as the tax benefits available now.
''Many people want to swap but don't know why,'' observes Stephen Monheim, senior vice-president and director of financial services at Butcher & Singer, a Philadelphia brokerage. ''You should know the direction you want to go and how to get there.''
Investors often get calls from their brokers about now, suggesting a year-end swap, and it may be in the investor's best interest. But whether or not it is, the broker gets a commission for each transaction, something that should be remembered before you agree to the deal. Make sure the savings at least outweigh the trading costs, which can run from 1/2 to 21/2 percent of the principal on either the buy or sell side of the deal.
You should also be sure that you're not sacrificing security, safety, or capital in the swap. Most brokers feel swaps should be done well before the end of the year.
''I think all the work should be completed before Thanksgiving,'' said Steven J. Hueglin, executive vice-president of Gabriele, Hueglin & Cashman Inc., a New York municipal bond house. ''As soon as people read this, they should call their broker.''
Just as some people often put off filing income tax forms until April 15, however, some tend to procrastinate on bond-swapping until December, Mr. Hueglin noted. He says December is the worst month for swapping, because so many other people have waited until then. This creates a last-minute rush that brokers have trouble handling and a surge of orders that are difficult to fill as demand picks up. Also, it gets harder to find a market for the bonds you want to sell.
Here's how the tax saving on a swap works: When you sell a security for a loss, these losses can be applied without limit to reduce taxable income on capital gains. The losses can also be used to cut taxable earned income by up to separate returns). Any excess losses can be carried forward indefinitely until they are exhausted.
A phone call from a broker suggesting a swap can also be a good time to review your overall investment portfolio. You may find that you've had some losses you weren't aware of; your personal circumstances may have changed and your investments haven't changed to match; or there may be new and better investment opportunities available that weren't around before.
An important thing to beware of in a swap is the ''wash sale.'' This is the sale and purchase of the same security made just so you can get the tax break. The Internal Revenue Service does not permit this. The tax break on a swap will be disallowed if the newly acquired security is bought within 30 days of the sale of a substantially identical security. ''Substantially identical'' means there was not enough difference in at least two features of the bonds being exchanged.
One way to make the bonds substantially different is to have the new ones come from some other issuer. You can also look for different maturity dates, coupon rates, and call provisions. A call provision gives the issuer the right to call in a bond before maturity, paying you all the principal but only the interest earned until then. Some bonds require issuers to wait longer than others before making a call.
Although some brokers believe you can get away with just one of these factors being different, most others are more cautious.
''We try to adhere completely to the law here'' by sticking to the rule of two different features, Mr. Monheim at Butcher & Singer says.
If you would like a question considered for publication in this column, please send it to Moneywise, The Christian Science Monitor, One Norway Street, Boston, Mass. 02115. No personal replies can be given by mail or phone. References to investments are not an endorsement or recommendation by this newspaper.