Investing: Tools for Tempering TaxesDavid Bogoslaw
Just as cash-strapped consumers are more inclined to clip food coupons than they were when the economy was on firmer footing, investors need to be conscious of ways to legally minimize what they pay the government in taxes on gains in their portfolios. "A lot of what makes an investment category tax-advantaged is based on the holding period of the asset," says Blair Anderson, a managing director at HighTower, an investment advisory firm based in Traverse City, Mich. "If you buy a position and sell it within a year, you're taxed at a higher rate"—a capital-gains levy of up to 35% instead of 15%. "It might be good for investors to identify which assets they're willing to hold for a longer period in [building] their portfolio for 2010," he says. Municipal bonds are of course the best-known example of tax-advantaged assets, and carry the best advantage of all—interest received on them is tax-free. But you need to be wary of bonds used to fund any nonessential services such as tobacco, sports stadiums, and airline terminals, since those are often subject to the Alternative Minimum Tax (AMT), says Anderson. High-Yield Muni BondsHe thinks muni bonds are a good bet for the next couple of years, as long as capital-gains and ordinary income tax rates remain at current levels. Given the expanded federal deficit, he believes it's inevitable that the government will raise income taxes, probably some time in 2011, and President Obama has talked about returning capital-gains taxes to the higher rates of the Clinton years. Anderson likes munis because they tend to provide a larger after-tax return than Treasury bonds based on higher yields. Keep in mind that munis don't enjoy the risk-free status of Treasury bonds, though they carry less risk than most other asset classes. For people seeking more income, Anderson recommends high-yield muni bonds, which he says should only be purchased through a money manager. He uses the American Century High Yield Muni Fund (AYMAX), citing the quality of its credit research department and portfolio manager Steven Permut's nearly 12-year track record, with no defaults in the portfolio. The fund is up 23.4% year-to-date as of Dec. 7. The success of high-yield muni funds depends on the ability of the manager's credit research department to go into the books of a municipality to understand the true value of the bonds, as well as any risk. Fund research is particularly important since the reason the bonds are paying premium yields in the first place is either the issuer is a smaller, lesser-known entity that doesn't get coverage from fixed-income analysts, or the bonds are unrated or uninsured because the issuer didn't want to pay for those services. Anderson likes fund managers who care more about preserving capital than risking wild fluctuations in asset values in the pursuit of higher returns. He prefers that the fund buy munis used to build sewers or to support a critical electric utility or the primary hospital in the municipality instead of higher-yielding ones to build a stadium, whose risk is tied to whether the local football team stays or moves away. Closed-End FundsNormally at yearend, investors would be able to pick up munis at a nice discount since closed-end muni fund investors will sell assets that have had losses regardless of their underlying value in order to offset gains in other parts of their portfolios. This year, however, the average discount is just 5% to 7%, compared with 25% a year ago. That's mostly because demand has increased on the much higher dividend payouts muni funds have been able to make this year due to ultralow borrowing costs, which have widened their yield spreads, says Cecilia Gondor, an analyst at Thomas J. Herzfeld Advisors and editor of the firm's monthly newsletter. One other tax-advantaged vehicle finding favor: master limited partnerships (MLPs), which have become more popular in these ultralow interest rate times due to the higher yields investors can earn vs. those on Treasury bonds, bank CDs, or money-market accounts. In developing oil and gas pipelines and other assets, MLPs may operate at a loss for the first few years and incur a lot of depreciation costs, which reduce net earnings.As a result, MLPs are likely to generate free cash flow in excess of earnings, which is treated as a return of capital, on which taxes are deferred until the owner sells the units. Roughly 80% of MLP distributions generally are classified as returns of capital. MLP Yield SpreadsAnd where yields on another popular tax-advantaged vehicle, real estate investment trusts, are currently at around 2% to 4%, yields on pipeline MLPs are 7% to 8%, having doubled over the past year, says Charles Goldblum, president of New York investment firm Hurley Capital. Yield spreads on MLPs vs. the 10-year Treasury note have widened from 2% in late 2008 to about 5.75% recently, while historically MLPs have traded with less market turmoil than the 10-year note. The primary tax benefit of owning an MLP is that you defer payment of taxes on the portion of the annual distribution that's considered return of capital but receive the entire annual distribution to offset living expenses or invest in other assets. Each distribution lowers the owner's cost basis on the MLP. If an investor's total annual distribution is $2 per unit and 80% of that is return of capital, which is deferred, he pays taxes only on 40¢ of each unit's income right now. Unlike capital gains, these distributions are taxed as ordinary income. The advantage is that by deferring the bulk of the taxes into the future, if you hold the units for a very long time you're likely to be in a lower tax bracket and taxed accordingly, says John Cusick, an analyst at Oppenheimer (OPY) who covers MLPs. MLPs are a preferred way to get exposure to the fixed-income market without being saddled with low yields or undue interest rate risk that comes with Treasury bonds. That said, the stock performance of these partnerships is linked to the return on the 10-year Treasury bond more than anything else, adds Goldblum at Hurley. Loss DrawbackOne drawback of MLPs is that any net loss when they're sold is considered passive under the U.S. tax code, which means it can't be used to offset income from other sources but must be carried forward and offset against future income from the same partnership. MLPs that build natural gas and oil pipelines or storage facilities are a safer bet than those that actually produce oil or gas because pipeline and storage capacity is leased at fixed rates through long-term contracts that generate cash regardless of fluctuations in energy prices. The cash flow of energy-producing MLPs rises or falls according to oil or gas prices. When energy prices go up, MLP yields typically follow, says Goldblum. Tax benefits of MLPs are even better when it comes to estate planning since on the owner's death they receive a step-up in cost basis where the value of the unit becomes the market value on the date of death. This eliminates capital-gains and deferred taxes on previous distributions when the assets pass to the owner's beneficiaries. Outside of MLPs and REITs, dividend-paying stocks offer investors tax-advantaged income, too, since their payouts are taxed at the qualified dividend rate of 15%, the same as capital gains. As always, tax-conscious investors must track developments in Washington, D.C. As of 2011, tax rates on both dividends and capital gains are scheduled to go back up to where they were before the Bush tax cuts of earlier this decade. That means that the window of opportunity for investors looking for a break could be closing soon.