A Quick Tax Review
The following discussion is for background and informational purposes only. It is not and should not be used for other than informational purposes.

Tax Loss Swap

In a tax loss swap, capital gains realized from the sale of equities and/or municipal bonds can be offset with a tax loss that is created through the sale of a municipal bond currently held at a loss.

For tax purposes, a gain or loss occurs when an asset is sold. The difference between the asset’s sale price and its adjusted cost basis will determine the magnitude of the gain or loss. The length of time from the purchase date to sale date determines whether the gain (loss) is short-term or long-term and hence the magnitude of the effect of taxation. Capital losses incurred during bond swapping are first applied against any capital gains and secondly against ordinary income. You can deduct capital losses against any unlimited amount of taxable gains. If you have no capital gains or if you have capital losses in excess of capital gains, you can use these excess losses to offset up to $3,000 of ordinary income per year. After you have used your capital losses to offset all capital gains and $3,000 of ordinary income, any excess losses can be carried forward to offset ordinary income in future years (for a period of eight years).

How to Avoid a Wash Sale

The proceeds from the sale of the municipal bond can be simultaneously reinvested in a different tax-exempt bond. The position in the municipal market can remain as close as legally permissible to the original position or take advantage of existing relative value opportunities that satisfy current investment opportunities.

The wash sale rules of the IRS Tax Code prohibit the recognition of a loss on any sale of securities if the holder purchases the same or substantially identical securities during a period of time extending from thirty days prior to thirty days after the loss sale. Essentially, the loss-taker must be exposed to market risk for the prescribed period of time in order to be able to effect a loss. To avoid a wash sale when executing a bond swap, the new bond should be sufficiently dissimilar from the original bond owned. The extensive number of municipal securities make them very advantageous for use in tax swaps. Of the variables that distinguish one bond from another, (coupon, rating, maturity, and issuer, as a general rule) a swap in which the issuer changes will almost always avoid the wash sale. In a swap where the issuer remains the same, the requisite change in coupon and or maturity will be a matter of opinion varying among tax counsel.

An Example

Consider a 5.25% coupon AAA GO bond maturing 1/1/30 purchased at par on 1/1/00. If we assume that the bond is sold on 9/1/00 at a yield of 5.75% for a price of 92.94, the realized loss is $7.06. If an investor had an equal amount of capital gains (for a bond with like credit quality and income stream), at a 28% capital gains tax rate, the person could reduce his tax liability by $1.98 per bond or $19.18 per $1,000 principal value.

Tax swapping is easier from May through the fall because: 1) historically this is the peak issuance periods of municipal bonds and 2) the volume of municipals available in the market tends to shrink at year-end. A period of a significant amount of bond calls and redemptions will correspondingly leave many bondholders with realized capital gains. Due to the possibility that rates could move lower and market conditions may erode tax spreads, investors should take advantage of current market conditions to rebalance their portfolios and take losses to offset gains. Investors should work with investment professionals to actively manage the composition of securities in their portfolio(s) during all times of the year, in order to improve portfolio returns.

Triple Witching Day

Definition: "Triple-witching" day is the third Friday of the month that ends each quarter. It marks the simultaneous expiration, at the close, of stock options, index options and index futures."

Implications: The impact of "triple witching" has been associated with increases in the volatility of the market. The increased volatility increases the uncertainty about prices of the underlying stocks.

Stock options that are exercised, or the underlying stock bought/sold, creates large additional volume. With unwinding large volumes of stocks, there is an increase in index arbitrage (i.e., the simultaneous purchase of index futures and the sale of a basket of stocks, or vice versa, when the values of the index and the underlying stocks become "out of wack" with each other). Meanwhile, some investors are trying to unscramble whether to, say, buy/sell a position, in options or futures contracts, similar to their current ones (i.e., roll-over the existing contracts) or get into different ones.

The increased volatility has prompted the options industry, with the blessing of the SEC, to take some action. Although options on the S&P 100 and on stocks still expire at the close, S&P 500 options and futures have been moved up to settle for cash based on opening prices on expiration Friday, according to Barron’s June 24 (1996) edition.

There is one other reason for the increase in volatility that the article did not even mention. The composition of the Russell 2000 index, a barometer for small-cap stocks, is reconfigured each June by Frank Russell Co., which created the index. Thus, there is added trading activity in the delisted stocks (i.e., removed from the index) as well as those added to the index.