In our travels, we’re running into a lot of people who are advocating that investors recognize all their portfolio losses whether they can use them in 2008 or not.
I conferred with Al Cappelloni, the director of the tax practice at my parent company, Vitale Caturano & C0., the largest regional accounting firm in New England. We concluded that, in many cases, this is a flawed strategy. Certainly, investors should consider recognizing portfolio losses if they can use them this year to offset realized gains and to offset income to the $3,000 limitation. But taking losses with the sole intention of generating a loss carryforward (“banking” losses) may not be the best strategy for investors.
To a large degree, investors will reap the benefits of losses whether they are taken or not. A cost basis above current price means that, going forward, the gains will be sheltered up to the basis. Consider a hypothetical situation of an investor who has owned IBM for over a year at $100/share when the current market price for IBM is $80, an unrealized loss of $20. Assume that the same investor has no realized gains to offset and has maximized his ability to use capital losses against income.
1)If IBM goes back to $100 and the investor sells, he will have no tax liability.
2) Consider a loss-harvesting alternative: the investor sells today, recognizes the loss which is carried into the next year, buys IBM back 31 days later (assumed at unchanged price of $80/share), enjoys the rebound to $100 share and sells. The investor now has a $20 gain which is offset by the $20 loss, so also no tax liability.
On the face of it, it would seem that the investor should be indifferent to harvesting unneeded losses or standing pat. However, the example does not incorporate transaction costs. It also assumes that this investor will be able to repurchase his security at the same price. Both of these are unrealistic — even in fee-based accounts, there is some trading cost in selling and repurchasing a security, although it is generally small. More troubling is the risk of being out of the market, or if a proxy is used to stay in the market (an index fund, for example), the risk of not being in the optimal portfolio. In the current environment, this is a particularly large consideration since maximizing the recognition of losses might require selling out all of an investor’s positions.
In addition, the loss-recognition strategy will restart the holding period for the security owned, making that security vulnerable to the higher short-term gains rates should it be sold for investment reasons within a year. Consider again, the above hypothetical IBM holding, but in this instance IBM quickly rebounds to 110 and is then sold. In scenario 1 above, the investor will have a long term capital gain of $10/share. In scenario 2, the investor will have a $30 short-term gain, offset by a $20 long term loss, netting out to a $10 short term gain. In this case, the investor is clearly disadvantaged by having “banked” losses as his gains are now subject to the higher short-term capital gains tax rates.
There is another problem with the take-all-losses strategy, an issue more subtle yet potentially more important. When investors carry forward unused capital losses, they are forced to use them against any recognized future gains. With a new administration entering Washington that has expressed an interest in raising capital gains, there may well be an advantage to timing the use of losses. For example, if in 2009 I were to believe that the maximum capital gains tax rate would increase in 2010, I might choose to pay taxes on recognized 2009 gains and postpone realizing losses until they are of greater value under a new tax regime. Investors who excessively recognize losses this year will be denied this flexibility.
There are some situations where banking losses makes sense. For example, if an investor knows with some certainty that he will be generating short term capital gains in future years. Going back to our IBM example, the investor might want to bank losses in IBM, after 31 days return to that security the long term (so if sold it will qualify for long-term tax rates) and have the losses available for use against future short term realized gains. However, this is indeed an unusual situation — consistent short-term treatment is more commonly associated with certain alternative investments or non-traditional trading strategies rather than long-term investment approaches. It is difficult to imagine having sufficient confidence in the ability of such vehicles to produce consistent gains as to influence the loss-realization decision. However, even with such confidence it is unlikely that the optimal course would be to bank all available losses.
One could also envision a scenario where it would be advantageous to bank losses before they disappear. However, given the current state of most portfolios, it seems likely that investors will have some time in 2009 and beyond to make those calculations. At the end of the day, there are few cases where banking all unneeded losses is optimal. The belief that this is a risk- and cost-free strategy is misguided. There is indeed a downside to such transactions, and these are risks without any real offsetting benefits.
So why is this take-all-losses strategy being promoted? It was possibly born in the days when financial advisors operated largely on commissions — December was typically the top revenue month for brokerage firms on the strength of loss recognition transactions – more losses recognized, more transactions, more revenue. Even in our fee-based world, I think there’s a desire of many advisors to try to demonstrate some value to their clients in an otherwise dismal year. From the narrow viewpoint of the investment advisors, it is quicker and simpler to take all available losses rather than coordinate with a client’s tax advisor. Finally, there may also be a desire to “reset the clock” psychologically and not have securities showing on the statement with large losses.
There’s a saying in poker that is often applied to investing: you can play your hand or you can play the bank, but you can’t play both. Investors should focus on holding the best portfolio to fit their risk tolerance and financial goals. Poorly conceived tax strategies needlessly disrupt this focus.