Considering taxes when you make an investment decision is especially important now. Many investors are sitting on unrealized stock losses that, handled wisely, can be used to offset profits, says Robert N. Gordon, the author of Wall Street Secrets for Tax-Efficient Investing (Bloomberg Press; $29.95). Gordon is president of Twenty-First Securities, a New York City investment firm that specializes in tax strategies. He recently spoke with Personal Finance Editor Susan Scherreik. Note: This is an extended version of the interview that appears in the Jan. 28 edition of BusinessWeek.
Q: A lot of people say you should make a good investment first and worry about taxes later. Doesn't your book suggest otherwise?
A: Not at all. Making a good investment decision always comes first. What people fail to realize is they can make the same investment bet in a variety of ways, each with a different tax consequence. The trick is to pick the investment that minimizes taxes in your situation.
Can you explain?
A: Let's say you want to invest in the Standard & Poor's 500-stock index. The most common way to do so would be to buy a mutual fund that owns the stocks in this index. But if you plan to cash out in less than a year, a futures or options contract tied to the S&P 500 offers more favorable tax treatment. With these futures and options, 60% of the profits are considered long-term and 40% short-term, regardless of how long you hold them. That means you'd pay taxes at a blended 27.44% rate if you're in the top tax bracket. By contrast, if you had purchased the mutual fund, you'd owe income taxes of up to 38.6% on short-term gains.
What if you're a long-term investor?
A: Opt for an exchange-traded fund that mimics the S&P 500, such as Standard & Poor's Depositary Receipts. Exchange-traded funds are more tax-efficient than traditional mutual funds because they have fewer capital-gains distributions.
Are tax-efficient strategies mainly for the wealthy?
A: No. Many strategies are simple and carry little risk. However, they require more creative thinking than investors usually do.
Q: How so?
A: You could invest in a money-market fund today and earn nearly 2% interest. Or you could buy a U.S. Treasury note maturing Nov. 15 with an 11.63% coupon because it was issued years ago, when interest rates were higher. The note recently traded at $1,081.25, above its $1,000 face value that you get at maturity, so it yielded 1.85%. When the note matures, you'll earn $97.94 in interest and have $81.25 in capital losses. You can use those capital losses to offset state taxes due on gains in most states except New York. With both investments, you earn the same amount of interest, but you get an added tax benefit with the Treasury note.
Q: A lot of investors are sitting on stock losses. What should they do tax-wise?
A: Let's say you want to continue to own a stock because you think it will rebound. In the meantime, you can still harvest the loss to offset capital gains on other investments, or take a $3,000 a year deduction against ordinary income taxes.
Q: How do you do that?
A: The wash-sale rule says if you sell a stock but buy it back within 31 days you can't claim a loss. My suggestion would be to double your stock position for 31 days, then sell the original shares. But limit your risk by hedging the second slug of stock with options.
Q: What does this strategy entail?
A: Let's say you own 100 shares and purchase the second 100 shares for $25 each. At the same time, you would sell a call option that gives the purchaser the right to buy 100 shares of the stock at $25 for 31 days. You would simulanteously buy a put option that gives you the right to sell the shares at $25 for 31 days. So no matter which way the stock price moves, you'll unload 100 shares at the current price in 31 days.
Q: What if you want to sell a stock, but you hesitate to do so because you'll owe capital-gains taxes?
A: The biggest risk of holding on to the stock is that the share price will fall, thus reducing or wiping out your profit. You can eliminate that risk without selling your shares immediately and triggering capital-gains taxes with an options collar.
Q: How does an options collar work in this situation?
A: Say the stock you want to sell is trading at $100. You simultaneously buy a put option at $90 and sell a call option at $105. If the stock falls below $90, exercising your put option will limit your losses. Of course, if the stock's price rises, you'll have to sell at $105 and won't realize further gains. An alternative, however, is to buy back the call options so you don't have to sell.
Q: Is there anything new in the tax laws investors should know about?
A: A tax rule that has just come into play is a new 18% capital-gains tax rate if you hold an investment five years or more. It applies to investments purchased after Jan. 1, 2001. However, for investments owned before that date, most investors can still qualify for the 18% rate if they do what's called a deemed sale. This type of sale lets you pretend that you sold an asset on Jan. 1, 2001, then immediately repurchased it.
Q: If you do a deemed sale, do you owe capital-gains taxes on your 2001 tax return?
A: Yes, that's the problem. You pay any capital-gains taxes owed on the position up to Jan. 1, 2001, at the 20% rate. The good news is that future gains will be taxed at the lower 18% rate, as long as you hold the investment until 2006. You need to tell the government on your 2001 tax return whether you want to do a deemed sale of older investments.
Q: Is doing a deemed sale smart?
A: That depends. It's a bad idea if you have a loss in a stock, because then you can't claim the loss to reduce your taxes. The answer is probably no again if you have a big profit in the stock. For instance, if you paid $10 a share for the stock, and its share price was $15 in January, 2001, the stock would have to climb to over $37 a share for the future tax savings to be worth voluntarily paying taxes today.
However, if you are at the break-even point, or think the stock price will soar over the next five years, then doing a deemed sale makes sense. To help you determine what's best in your situation, use the calculator at our Web site.