Sponsored by Gurtin Municipal Bond Management, a PIMCO Company
Given the nearly decade-long equity bull market that we’ve been experiencing — and continue to experience today — you might be realizing substantial capital gains from your equity investments. And, while you are likely enjoying the performance of your investments, your consequent tax liabilities upon liquidation might not seem as attractive.
In light of these considerations, the investment practice of tax loss harvesting can be used to help offset capital gains, and thereby increase the overall tax efficiency of an investment portfolio. Furthermore, by executing tax loss harvesting in municipal bond portfolios, you don’t simply defer taxes like you would in equities.
What Is Tax Loss Harvesting?
As you realize capital gains and earn income on your taxable investments, tax liabilities accrue. Your ultimate tax bill can be substantial, especially when your assets have appreciated over a long period of time. Tax loss harvesting is a practice that allows you to partially reduce, or potentially eliminate accrued tax liabilities by selling securities that have depreciated in value, thereby netting out realized losses from gains.1 Industry professionals have extensively studied the general practice of tax-efficient investing, and tax loss harvesting in particular, and have reported on the value added for taxable investors who execute the process appropriately.2
Why Harvest Losses in Municipal Bonds?
Tax loss harvesting in the municipal bond asset class can potentially be extremely efficient. Unlike tax loss harvesting with equities, exchange traded funds (ETFs), and mutual funds — which simply defers the payment of taxes into the future, generating value solely from a net present value perspective3 — tax loss harvesting with municipal bonds can permanently eliminate tax liabilities.
Example No. 1: ETF Tax Loss Harvesting
Consider the example of harvesting losses on an ETF tracking the S&P 500, and swapping into a second ETF tracking the same underlying index.4 Let’s assume the original S&P 500 ETF you purchased has a cost basis of $100, and the market price of the original S&P 500 ETF has declined from $100 to $90, allowing you to realize a $10 loss upon sale that can be used to offset realized capital gains. However, when you finish executing the swap by purchasing the second S&P 500 ETF, your cost basis on your S&P 500 ETF investment resets to the purchase price paid for the second S&P 500 ETF.
For simplicity, let’s assume that the two ETFs track each other perfectly, and therefore, you’re purchasing the second ETF at a price of $90, or $10 less than the original cost basis of the first ETF. Ultimately, when you liquidate the second ETF (no matter what the price is at time of liquidation), you will realize $10 more in gains relative to an alternative scenario in which you decide not to tax loss harvest by simply holding the original S&P 500 ETF investment until final liquidation.5
Example No. 2: Municipal Bond Tax Loss Harvesting
From a tax loss harvesting perspective, municipal bonds, and other fixed income securities with fixed, finite lives operate quite differently than other investments with indefinite lives. Assuming you are planning to hold bonds to maturity, tax loss harvesting allows you to reduce or potentially eliminate current tax liabilities — without creating or increasing future tax liabilities.
For example, imagine you currently own a bond with an adjusted cost basis6 of $120, which is now priced in the marketplace at $110. You realize a $10 loss on the sale, and reinvest into a similar security with an identical maturity date, priced at $110. When the second bond matures, you have no capital gains because your purchase was executed above par and the bond matured at par. However, you have locked in a valuable $10 capital loss on the original holding, which can be used to offset other gains realized elsewhere in the portfolio. If you had simply held the original bond to maturity, no such realized loss would exist.
This process works best when there are bonds available in the marketplace that you can purchase at a premium. Fortunately, municipalities typically issue high-coupon bonds at significant premiums above par precisely because they are highly tax-efficient structures.7
One other reason municipal bonds represent an attractive vehicle for tax loss harvesting is that there is an abundance of issuers in the municipal marketplace — and multiple issuances per issuer.8 This allows for timely re-investment while avoiding triggering a wash sale, thereby minimizing the impact of cash drag and maintaining consistent portfolio construction.
Benefits of a Tech-Driven Approach to Tax Loss Harvesting
We believe our systematic, technology-driven process for municipal tax loss harvesting enables our firm to:
- Efficiently identify securities across eligible municipal bond accounts that may be appropriate for tax loss harvesting
- Perform a thorough analysis of the liquidity, yield, and structure of identified securities on a bond-by-bond basis, to help ensure that we add value for you on an after-tax basis
- Aggregate blocks of identical CUSIPs held across multiple eligible accounts, in an effort to deliver superior execution
- Avoid triggering wash sales, which can negate the potential benefits of tax loss harvesting
If you have any questions about how we believe our award-winning9, algorithm- and technology-driven process for tax loss harvesting allows our firm to identify opportunities in the municipal bond market in real time and appropriately manage risk, to deliver tangible benefits, please contact us by calling 858-436-2200 or by emailing [email protected] today.
Alex Etzkowitz, Vice President in Investment Research & Strategy at Gurtin Municipal Bond Management, a PIMCO Company
If you liked this blog post and would like to read more, please visit:
- Case Study on Municipal Tax Loss Harvesting
- Benefits of Municipal Bond Tax Loss Harvesting
- Gurtin Municipal Bond Management's Tax Loss Harvesting Service
Request a complimentary portfolio review to receive a detailed assessment of the credit quality of your municipal bond holdings: Request Portfolio Review.
See related Gurtin disclosures.
1 If capital losses exceed gains, they can also be used as a deduction subject to limitation, and can be carried forward onto future tax returns and netted off of future capital gains. For a summary see: https://www.irs.gov/newsroom/capital-gains-and-losses-10-helpful-facts-to-know, or for more in-depth information see IRS Publication 550, Ch. 4, https://www.irs.gov/pub/irs-pdf/p550.pdf.
2 Arnott, Berkin & Ye (2001); Wilcox & Fabozzi (2013), Ch. 8; Bergstresser & Pontiff (2013); Kalotay & Howard (2014).
3 For more on tax loss harvesting ETFs, see Bouchey, Brunel & Li (2016)
4 The analysis in this paragraph assumes that such a swap is not treated as a wash sale.
5 Or, in the event that the market continues to decline and shares are liquidated at less than $90, the investor will realize $10 less in losses than the scenario in which tax loss harvesting is not undertaken.
6 Adjusted cost basis in this context is defined as the original cost basis adjusted for amortization/accretion.
7 Landoni (2017).
8 Kalotay (2016). As of 2011, there were over 1 million distinct municipal bonds outstanding according to U.S. Securities and Exchange Commission (2012).
9 Gurtin was recognized by the WealthManagement.com 2019 Industry Awards in the Asset Manager: Fixed Income category in recognition of our tax loss harvesting process. Third-party rankings and recognition are no guarantee of future investment success. Working with a top-rated advisor does not ensure that a client or prospective client will experience a higher level of performance. Ratings should not be considered an endorsement of the advisor by a client nor are they representative of any one client’s experience. The WealthMangement.com Industry Awards are independent awards produced annually. WealthManagement.com considered more than 650 total entries from more than 262 companies. For consideration within the Asset Manager: Fixed Income category, Gurtin submitted information for a product, tool, or initiative launched within the last year. After submission, the WealthManagement.com judging panel, which consisted of fourteen judges from top names in the industry, determined 166 finalists. Later, each judge received an online voting form where they ranked the finalists in each category, with the aggregate determining the 61 Industry Award winners. Winners were selected based on quantitative measures of their initiatives — such as scope, scale, adoption and feature set — along with qualitative measures, such as innovation, creativity and new methods of delivery. Neither the firms nor the firms’ employees pay a fee to WealthManagement.com in exchange for inclusion in consideration for the Industry Awards, Asset Managers: Fixed Income category.
