William Creekbaum: Should you consider tax swaps in your investment portfolio?

Transactions that allow the proceeds from the sale of a security to be simultaneously reinvested into another security are sometimes referred to as a "swap." The combined transactions of the swap are designed to provide benefits to the investor in terms of income, credit quality, maturity target or call features and diversification, although keep in mind, diversification does not guarantee a profit or protect against a loss in a declining financial market. Often, there may be tax benefits to the swap as well.

Many individuals have unrealized capital gains and losses in their investment portfolios that may be unlocked through a swap transaction, known as a tax swap. These transactions require the sale of a security to offset a loss or a gain elsewhere in your portfolio. Such a swap may convert a paper loss into a real tax saving. You should consult your tax adviser before making any tax-related investment decisions. You might consider tax swaps if you have capital gains or losses from the sale of a security, or expect to sell a security at a profit or loss in the near future. While swaps can be done at any time of the year, many investors use the period toward the end of the tax year to review their portfolios for tax swap opportunities.

For example: if you sell an equity (stock) position for a significant gain, you could offset the capital gain by selling a fixed-income (bond) holding for a capital loss, using the proceeds to buy a new bond with a higher coupon.

Capital losses can be used to offset capital gains on a dollar-for-dollar basis. For tax reporting purposes you must first net short-term gains against short-term losses (securities held for one year or less), and long-term gains against long-term losses (securities held for more than a year). Any remaining short- and long-term gains and losses can be netted against each other. If net capital losses still remain, up to $3,000 may be used to offset ordinary income. Any unused capital losses are carried forward indefinitely.

The Internal Revenue Service requires a taxpayer to defer any tax loss generated from the sale and purchase of "substantially identical securities" if the transactions occur within 30 days of each other (regardless of whether the sale is before or after the purchase). This is commonly referred to as a "wash sale." Generally, securities are not considered identical when they have different issuers or, for fixed income securities, where there are substantial differences in either maturity date or coupon rate. You should consult your own tax advisor before making any swap decision and to determine whether a sale will be considered a wash sale.

As with all investments, equity and fixed income securities have inherent risks which you should consider before investing. These include equity market risk, interest rate risk, credit risk, reinvestment risk and call risk. In particular, should you sell your security in the secondary market, the price you receive may be more or less than your original purchase price or maturity value. In addition, any swap should always be considered in relation to your financial objectives and goals and you should consider any transactions costs involved.

Tax swapping can be an important tool in managing your investment portfolio. As the financial markets and your financial goals and circumstances change, the investments in your portfolio should be adjusted accordingly. Tax swaps are one way you can effect these adjustments. You should consider annual (at a minimum) portfolio reviews and maintenance as a must for efficient and effective investing.

Your financial adviser can work with you to identify possible bond or equity security swap opportunities in your portfolio.

• William Creekbaum can be contacted at 689-8704 or by e-mail at William.a.creekbaum@mssb.com.


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