Taxes are an integral part of portfolio performance, since to the extent we can reduce the tax bite for clients, we will increase their total return. In this article, part of a series of blogs I’m writing for ThinkAdvisor’s 22 Days of Tax Planning Advice: 2015, we’ll discuss bond swaps and, more specifically, tax swaps.
Bond Swap Basics
A bond swap is a common investment strategy which involves selling one bond and immediately purchasing another with the proceeds. There are several types of bond swaps including quality swaps, yield swaps and tax swaps. We’ll focus on the tax swap and explain how it reduces an investor’s federal income tax liability.
Tax Swap Basics
A tax swap is one of the most common of all bond swaps. It involves the sale of a bond which is priced below its basis. For example, an investor may own a bond which has a basis of 103.50 and a market value of 101.25. Because its market value is lower than its basis, it would be appropriate in a tax swap. I should note that the market value of the bond does not have to be below par, only lower than its basis.
Let’s assume you own a 20-year, AA quality, corporate bond with a 5.0% coupon. Further assume you bought it ten years ago at 102.50, and because its credit rating has fallen to BBB+, it’s now priced at 98.50. If you held the bond until maturity, it would be redeemed at par and part of your loss would be eliminated.
In a tax swap, you sell the bond and use the proceeds to buy another bond. As a result of the sale, you are able to use the capital loss to offset other capital gains you might have. If you have no other capital gains, you can use the loss to offset up to $3,000 of ordinary income per year until it is fully used. If you are unable to use all of the loss, you can carry it over indefinitely until it’s fully used.