The following analysis is based on “Tax-Smart Portfolio Evaluation and Performance Measurement”, in an upcoming article by Andrew Calot Portfolio Management Journal, And blackout “Tax-efficient trading of municipal bonds, “From Financial Analyst Journal.
Say you have a portfolio of tax-free municipal bonds. How do you determine its value?
|Equal amount||Coupon||Maturity time||Date of purchase||Purchase price||Current basis||Current price|
|100,000||5%||Eight years||Two years ago||113.3||111.0||106.0|
|100,000||2%||Eight years||Two years ago||100.0||100.0||95.0|
If you liquidate the portfolio, the revenue will be $ 201,000. But these bonds are in a taxable account – munis should not be kept in the IRA – and have sales tax consequences.
The current tax base of 5% bonds purchased for 113.3 is 111. At the applicable 20% tax rate, selling will reduce your tax by $ 1,000. Therefore, To you The actual value of 5% Muni is $ 107,000.
Let us apply the same analysis to 2% bonds. Selling at Rs 95 would result in a loss of $ 5,000 and tax savings of $ 1,000. Therefore, on a post-tax basis, 2% Muni is valuable At least You 96,000.
But discount munis are more complicated, because the so-called de minimus tax effect must be taken into account. D minimus refers to the tax treatment of the discount. Profits from a large “non-de-minimized” discount are taxed at about 40% of normal income at maturity.
For a 2% bond, a buyer at 95 will have a 2 point tax liability on a 5 point gain. Based on current prices, the price of 2 points eight years ago is 1.7 points today. And this future tax cost is revealed at today’s 95 price – without it, the value of 2% s would be 1.7 points higher, or 96.7!
The 95% to 2% Munir buyer is being given fair compensation for future tax expenses. But how valuable are these bonds to you, considering that you bought them equally?
Since your tax base is 100, you do not pay tax when the 2% bond matures, and therefore the current value of your cash flow is 96.7. It surpassed the post-tax selling price of 96 by 0.7 points! In dollar terms, Keep the value Your 2% Muni is $ 96,700. Since the hold value exceeds the after-tax income from the sale, it would be a mistake to sell only to save tax.
In short, the actual value of your portfolio is $ 107,000 + $ 96,700 = 203,700, which exceeds the market value of $ 201,000 by $ 2,700. Acceptability is that on a post-tax basis, the value of a portfolio may differ greatly from its reported value. Selling at a loss can be beneficial, but beware of discount munis: you can save on taxes but not enough to compensate you for the high cost of holding. The goal is to maximize post-tax value rather than savings on taxes.
Looking at your Mooney portfolio through a tax-smart lens will open your eyes to the post-tax value.
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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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