Tax-smart management of your Mooney portfolio

In “The Real Value of Your Money Portfolio” I have considered alternative ways to measure investor-specific value of a taxable portfolio. The market price is not reasonable, as liquidating the portfolio will result in taxation, and therefore the liquidation value will be different from the market price. Instead of the market price, I recommend the “tax-smart” price, which is higher than the after-sales price and hold value of the security.

Let’s calculate the tax-smart value of a 5% bond of 10 years bought two years ago at a price of 113.3, which is based on the current tax of 111. Today, with eight years left to mature, the market value is 106. A sale at 106 would create a 5-point long-term capital loss and therefore a 1-point tax savings at a 20% tax rate, resulting in a 107 after-tax income after the sale. Smart value 107.

Should you sell this bond at 106 and realize a 5-point loss, or should you hold it?

There are two investment strategies: sell and reinvest, or do nothing. In the case of sales, the after-tax income is reinvested as 5% as an 8-year bond, thus increasing your holding by an equal amount of 107/106 factor.

Let’s calculate the tax-smart performance of the two strategies after two years. What if the rate goes down and the price goes up from 106 to 110? What if the price is reduced to 102?

Financial Analyst Journal Current Issue Tile

The two strategies are shown in the table with tax-smart portfolio values. Note that the tax base depends on the strategy: Under the tax-nothing strategy, based on the original 113.3 purchase price, it is 109.782. Under 106 strategy sell and repurchase, it is 105.352, and the imaginary amount of investment has increased by 107/106 factor. The tax-smart returns measured by the IRR depend on the terminal tax-smart portfolio value and the coupon interest received within the year.

In Scenario 1: 3 the price rises to 110

Year 2 Tax-Smart Price ($ M) Strategy in 1 year Year 3 Market Price ($ M) Year 3 base ($ M) Year 3 Tax-Smart Price ($ M) Adjusted Semi-Annual Coupon ($ M) Year 3 Return (%)
107.0 Sell ​​/ reinvest 111,038 106,346 111,038 2,524 8,414
107.0 Do nothing 110,000 109,782


2.500 7,426

If the price rises to 110, the return is 8.414% based on second year sales, and 7.426% without sales. The roughly 1% difference is due to the opportunity not to recognize capital losses at the end of 2 years – once prices rise, such opportunities can be lost forever.

Scenario 2: Price drops to 102 in 32

Year 2 Tax-Smart Price ($ M) Strategy in 1 year Year 3 Market Price ($ M) Year 3 base ($ M) Year 3 Tax-Smart Price ($ M) Adjusted Semi-Annual Coupon ($ M) Year 3 Return (%)
107.0 Sell ​​/ reinvest 102,962 106,346 103,639 2,524 1.589
107.0 Do nothing 102,000 109,782 103,556 2.500 1.466

If the price drops to 102, the performance of the tax-loss selling strategy is still somewhat better: 1.589% vs. 1.466%. The difference is partly responsible for the larger interest income from re-employment under the tax-loss sales strategy and it also depends on the correction of the basis relating to the different purchase prices.

There is an added benefit to understanding losses and reinvesting: it re-launches the short-term watch. Long-term losses can be deducted by 20%. Short-term losses, or those that have occurred in less than a year, can be deducted at a much higher rate of 40%, provided that short-term gains are offset. It is estimated that if the market price falls to 102, a loss of 3.384 (106.346-102.962) will result in 1.354 tax savings. The tax-smart terminal value will increase from 104.316 and return 2.223%, to 1.589%.

Image tiles the basis of high yield analysis

In short, Tax-smart portfolio assessment hints at opportunities to improve after-tax performance by acknowledging losses. It identifies sales opportunities by comparing post-tax revenue from sales to price retention. Sales and reinvestments are particularly effective if prices improve later, due to the opportunity associated with being inactive. If prices subsequently fall, the resumption of the short-term watch provides an opportunity to identify short-term losses at a higher effective tax rate, which improves performance more than doing nothing.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.

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Andrew in black

Andrew Kalotai is a leading authority in the evaluation and management of municipal bonds. His recent focus has been on maximizing the after-tax performance of accounts managed individually by dynamic investment and sales strategies. His organization’s fixed income analysis is used by major asset managers and risk-management platforms. 1 Before the founding of Andrew Kalotai Associates in 1990, Colotte was with the Salman Brothers. Prior to Wall Street, he was at Bell Laboratories and AT&T. Academically, he was the founding director of the undergraduate financial engineering program at the Polytechnic University (now part of New York University). He is the co-author of CFA Level II Reading, Fixed-Income Analysis. Colot holds a BS and MS degree from Queens University and a PhD degree from the University of Toronto, all in mathematics. He was inducted into the Hall of Fame in 1997 by the Society for Standing-Income Analysts.

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