You've invested heavily in real estate investment trusts for your income-needy clients. And those investments, up to this year, have worked well. But 2007 has been tough on REITs. The Dow Jones Equity All REIT Total Return Index is down more than 5 percent year to date. In particular, the iShares FTSE NAREIT Mortgage REITs (REM) exchange traded fund, which you bought earlier this year because of its high yield, has gotten slaughtered--down 40 percent. However, you think the worst is over for REITs, your clients still need the income, and you believe it is a good idea to maintain exposure to the sector. Yet you would love to harvest short-term losses in REIT investments purchased in 2007 to offset realized gains you took during the year.
Tax harvesting should be top of mind with advisors around this time of year, and for good reason. Time is running out. And with the end of the year nearing, clients are starting to look to April 15 and trying to get a handle on the tax hit you are likely to hand them.
Remember that you can offset realized gains with realized losses. Furthermore, you can take up to $3,000 in realized losses every year to reduce your client's taxable income. Finally, realized losses created but unused in one year may be carried forward to future years.
Talking about investment losses in 2007 may sound out of sync with what has been happening in the stock market this year. After all, many market indices have done well in 2007: Through the first three quarters of this year, the Dow Jones Industrial Average, S&P 500 Index, S&P 400 MidCap Index, S&P 600 SmallCap Index and the NASDAQ Composite were all at or near double-digit increases for the year. Thus, it would seem to be a reasonable assumption that tax-harvesting opportunities are limited this year.
That assumption would be wrong.
For example, while the Dow Jones Total Market Index is up 9.5 percent this year, 48 percent of the more than 1,500 stocks in the index were down through the first three quarters. And on the ETF side, approximately one out of every five ETFs was showing a loss through the first nine months of this year.
The upshot is that your clients are probably sitting with losses in some investments--losses that can be valuable if harvested in a way that reduces their potential tax liability without disturbing your overall investment approach.
Just how valuable can tax harvesting be to a client portfolio? The consensus among researchers is somewhere in the vicinity of 0.5 percent to 1.5 percent per year in increased after-tax returns. Those are big numbers, especially over a long period of time.
Another way to look at that after-tax bump from tax harvesting is that the amount probably matches up pretty closely to your annual management fee. That means that advisors can pay for themselves simply by smart tax harvesting. That's a tremendous selling point for your services and one that can help differentiate you from the many advisors that fail to provide tax-harvesting services for their clients.
One way to improve the tax friendliness of client portfolios is with ETFs. For starters, ETFs tend to be more tax efficient than mutual funds. That's because ETFs eliminate one of the primary drivers of taxes in mutual funds: shareholder redemptions. When shareholders redeem shares in a mutual fund, a portfolio manager is sometimes forced to sell stock to meet those redemptions. That selling creates potential tax liabilities if the fund manager is forced to sell winners.
The prospect of tax liabilities caused by significant fund redemptions looms large for investors in 2007, especially for holders of domestic funds. Indeed, the vast majority of net inflows to mutual funds over the last year have gone to international funds; domestic funds as a group have been experiencing outflows. Those outflows may very well trigger fairly substantial capital-gains distributions to domestic fund holders in 2007.
The good news for ETFs is that they don't have the redemption problem. Since an ETF trades on an exchange like a stock, selling doesn't require forced redemptions.
ETFs also tend to be friendlier than mutual funds when it comes to portfolio turnover. Since ETFs are based on underlying indices, and those indices tend to be fairly static, most ETFs do not have the portfolio turnover that can occur in some mutual funds. And with greatly reduced turnover comes the likelihood of fewer realized capital gains to be passed along to investors.
Aside from their inherent tax efficiency, ETFs are also a useful tool for tax harvesting. By selling one ETF and buying a similar, but not identical, ETF, an investor can lock up losses that he or she can use to offset gains, yet still maintain sector or market-cap exposure.
To be sure, such tax "swaps" have to be done with care so as not to run afoul of the "wash sale" rule. This rule states that losses on a sale of an investment may not be used as losses for tax purposes if the equivalent security is purchased within 30 days before or 30 days after the date of sale. In a nutshell, the IRS wants to make sure investors don't generate tax losses while maintaining what the IRS calls "substantially identical" investment exposure.
That phrase "substantially identical" does raise some questions for investors. For example, is selling one REIT exchange-traded fund and immediately buying another REIT exchange-traded fund permitted under the wash-sale rules? That's not clear. Anytime you're dealing with the vagaries of the tax code it is good to get a second and perhaps even a third opinion from a qualified tax professional. However, it would seem that as long as you are not swapping ETFs that look and smell, well, identical in every way--holdings, expense ratios, sponsors--two REIT ETFs could reasonably be construed as different investments.
That's not to say that swapping, for example, an open-end mutual fund that invests in the S&P 600 SmallCap Index with an ETF that invests in exactly the same S&P 600 SmallCap Index would pass the smell test with the IRS. In this case, it would appear that you are investing in "substantially identical" investments. However, even in this scenario there are no doubt some people reading this who would argue that an ETF and an open-end mutual fund are different investments because they have different structures, different sponsors, and perhaps different expense ratios.
Of course, how far you want to push the wash-sale rule is a matter between you and your clients. However, it's clear that ETFs provide plenty of swap options that should still keep you on the straight and narrow with the IRS. The table on page 55 lists ETF "doppelgangers," funds that match up rather closely in terms of investment objectives, yet should be different enough for tax-harvesting purposes.
As an example, let's get back to the REIT scenario. The advisor wants to realize losses on REIT investments but still wants to maintain the same exposure to the group. In this case, the advisor could sell the iShares FTSE NAREIT Mortgage REITs fund and buy any number of other ETFs focused on REIT investments, such as the iShares Dow Jones U.S. Real Estate (IYR) fund or the Dow Jones Wilshire REIT (RWR) exchange traded fund.
In addition to REITs, another sector where losses are likely this year is financials. The sub-prime meltdown has inflicted plenty of damage on the stocks of banks and certain investment firms. For the same reason you own REITs, you probably own financials--on average, they tend to sport higher yields. If you still like the group but want to realize losses to offset gains, you have a number of swap alternatives among ETFs, including Financial Select Sector SPDR (XLF) and iShares Dow Jones U.S. Financial Sector (IYF), which are listed in the table.
Do you realize that ETFs are useful for tax-harvesting purposes--not just with other ETFs, but also with individual stocks? For example, Pfizer is down some 37 percent from its 2004 high of nearly $39. If you bought the stock at any period during the last four years, it's likely you have a loss in these shares. Perhaps you have run out of patience with Pfizer and wouldn't mind taking the loss to offset some realized gains. But you are concerned about the overall market and believe the drug group represents a nice defensive sector at this time. Thus, you still want exposure to the group. One potential strategy would be to sell Pfizer and buy an ETF focused on health-care stocks. You could buy a broad-based health-care ETF, such as the iShares Dow Jones U.S. Healthcare (IYH) or something more focused on pharmaceuticals, such as the PowerShares Dynamic Pharmaceuticals (PJP). You could slice the health-care sector even narrower by considering one of the several XShares ETFs focused on such specialty areas in the health-care market as Cancer (HHK), Infectious Disease (HHG), or Dermatology (HRW).
If you have losses in open-end mutual funds, selling the mutual fund and buying a similar ETF is another harvesting strategy. For example, let's say you own a Russell 2000 index fund. You have a loss in the fund, but you still like small-cap stocks for diversification purposes. You could sell the Russell 2000 fund and buy the iShares S&P SmallCap 600 (IJR) ETF. True, the S&P 600 is a different animal from the Russell 2000. But both focus on small-cap stocks and would preserve your exposure to that style box.
Finally, you can use ETFs to turn short-term gains into long-term gains. For example, let's say you bought Intel at the beginning of this year. The stock has been a solid performer for your clients, rising nearly 30 percent. But you're getting nervous about the semiconductor sector and would hate to see those profits evaporate. However, you would prefer realizing long-term gains (which are taxed at a maximum rate of 15 percent) versus short-term gains (which are taxed at your client's ordinary tax rate). You need to hold Intel for another two months in order to push the gains to long term. One strategy is to maintain your position in Intel but hedge the position by buying the ProShares UltraShort Semiconductor (SSG) exchange traded fund. Daily price movements of this ETF are linked to the inverse direction of the Dow Jones Semiconductor Index. Thus, if semiconductors decline, this ETF should increase in value, providing an offset to the likely decline in Intel shares. Once the Intel shares are held more than 12 months, you can sell both positions and realize the long-term gains on Intel.
If you do plan to tax harvest, make sure you keep the following points in mind:
Tax harvesting does require buying and selling of investments, which means you will incur transaction costs. Nowadays these costs are usually nominal. Still, trading costs represent a drag on the portfolio, so you'll need to consider them when looking at tax-harvesting opportunities.
To maximize the value of a tax-harvesting strategy, your client should reinvest the tax savings generated by the strategy. For example, if tax harvesting saves your client $5,000 in taxes, you should encourage him to reinvest those savings in the portfolio.
Chuck Carlson, CFA, is chief executive officer of Horizon Investment Services and the author of Winning With The Dow's Losers (HarperBusiness). David Wright, CFA, provided research assistance for this article.