How to Take Losses While Keeping Your Allocation

Investing
How to Take Losses While Keeping Your Allocation
By David Edwards
Special to TheStreet.com
9/30/2002 7:28 AM EDT
URL: http://www.thestreet.com/p/rmoney/investing/10044884.html

With the S&P 500 down 25% since Jan. 1, the Nasdaq down nearly 40%, many companies trading at 52-week lows, the average investor very likely has both stocks and mutual funds showing a capital loss. Over the next one to five years, I'm reasonably confident that the stock market will resume its historic upward trend, but between now and year end, there are techniques that I will apply to my clients' portfolios to make the best of losses we've sustained this year.

How the IRS Treats Gains and Losses

In calculating your taxes, gains on stock sales held one year or less are taxed at your income rate (max federal tax rate is 39.1%), gains on stocks sales held more than 1 year are taxed at the capital gains rate (max federal rate is 20.0%.) You can net short-term gains and losses to reduce or eliminate the short-term tax, and likewise net long-term gains and losses to eliminate the long-term tax. If you have a net short-term loss, you can apply the balance against a net long-term gain. If you end up with a net loss, either short or long term, you can reduce your taxable income by the lesser of $3,000 (joint or individual returns) or the net loss. The remainder is rolled over to future years.

So in normal years, a diligent investor would keep careful track of gains accumulated through the year, then take just enough losses in the fourth quarter to zero out the gains, resulting in a no-tax bill.

Tax Strategies In an Abnormal Year

Hardly anything has gone right this year, either for professional fund managers or individual investors. You may have a portfolio full of first class companies, many down from where you bought them. Perhaps 90% of mutual funds are showing a loss YTD, we'll know for sure when the quarterly reports are published later this week. Gains, except for short sellers or particularly nimble day traders, are hard to come by this year. You could just sit tight and wait for the market to recover. Alternatively, you could "harvest" tax losses now, and roll these losses over to offset gains in future years.

Mutual Fund Swaps

· The Next Janus? A Look at Pimco, Wasatch and Oakmark
Yes, there are some similarities, but also vital distinctions.

· Time to Jump Into Junk? A Look at High-Yield Bond Funds
The risky market has pushed yield spreads to near-record highs. Some managers see opportunity.

You may be invested in an actively managed fund like the Janus Fund, which is down 60% over the last 30 months. Take the loss now, roll the proceeds into another fund in the same general category (e.g. large-cap growth.) Not sure which funds are running equivalent strategies? Look at Morningstar's "Analysts Picks for recommendations within the category (e.g. large-cap growth). Generally speaking, diversified mutual funds in the same style and capitalization boxes move together, but there's enough variation in the actual positions that from the IRS's perspective you have invested in a "different" asset and have not run afoul of the "wash sale" rule (more on "wash sales" below.)

Stock Swaps

You might have confidence that double-digit growth will resume in telecommunications equipment in the next year or two, but meanwhile you're showing a substantial loss in JDS Uniphase (JDSU) . Take the loss now, roll the proceeds into a similarly positioned company like Cisco (CSCO) , hopefully upgrading your portfolio in the process. For a quick overview of companies in the same industry group, look at Market Guide's "Ratio Comparison Report."

Wash Sales

If you have a position in, for example, the Vanguard Index 500 Portfolio, you might think that you can realize a loss in that fund, roll the proceeds into another index fund like the Schwab S&P 500 . Unfortunately, you have maintained the exact same exposure to stocks (index funds have identical investments in Wal-Mart (WMT) , General Electric (GE) , Johnson & Johnson (JNJ) , Microsoft (MSFT) , etc.).

The "Wash Sale" rule disallows realizing losses if you roll the proceeds of a sale into a "substantially similar" security within 30 calendar days. You might argue that these funds are run by different fund companies, have different management fees etc., but who really want to have arguments with the IRS? Instead, roll the proceeds of an index fund sale into an actively managed large-cap blend fund like Vanguard Growth and Income.

You might absolutely, positively want to maintain a position in a specific company. You can sell the stock now, and buy it back on the 31st calendar day past the sale. There's a risk that the company will rally substantially over the next month, but it's a risk you'll have to take to capture the loss. You can't use options to lock in the current price because that maintains an open position from the IRS's perspective. For example, you might sell a position in J.P. Morgan (JPM) for $19 a share and buy call options (strike $20, December expiry). Even if you didn't exercise the calls until expiration three months from now, the IRS would disallow your September sale of the stock.

The Bottom Line: No one likes to realize losses, but prudent review of your current situation can retrieve $20-$39 per $100 lost.

David Edwards is a portfolio manager and president of Heron Capital Management, a New York management firm. At the time of publication, his firm was long General Electric, Wal-Mart, J.P. Morgan, Cisco, and JDS Uniphase, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Edwards appreciates your feedback and invites you to send it to David Edwards.