On Capital Gains & Losses Conclusion-Taxable Accounts.

Today and tomorrow we'll finish our summer series on capital losses with a look on how to apply this to client accounts. For a past review of this series, please link here: http://lumencapital.blogspot.com/2009/07/on-capital-gains-losses-part-vii.html. Today I'll cover some thoughts of what to do with taxable investment accounts. Tomorrow we'll tackle the issue of tax-deferred accounts such as IRAs.
Earlier in this series I indicated that investors need to first assess the reason for how losses have occurred in their portfolios. If investing is done correctly losses principally are made from three causes: Bad investment timing, bad investment thesis and a market crash. Before doing anything investors need to review the nature of how their their losses occurred in order to determine what kind of investment tactics should be used. Of course investors should also review whether any of the principles we are about to discuss apply to their own personal situation. They should either do this on their own or with a financial or tax advisor. For now we are reviewing in general what we believe investors should consider. Their own personal situations may vary.

In the case of a bad investment thesis these assets should either be sold or marked for a sale at some more opportune moment. Investments that have declined largely due to poor market timing need to be reviewed on an individual basis. This review of the reason for owning a security in this situation should lead to a decision to lower the cost basis by adding to the security, removing it from the portfolio or leaving it alone for the time being. Finally we must deal with what we believe investors should consider in the current environment which is the results of a market crash.*

There is no better example of bad market timing than when owning an investment prior to a market crash. But a market crash is less about the issues with a single company or industry than a representation of a rapid and panicked reordering of the investment world. As such when the dust settles investors need to reassess their portfolios first with a renewed outlook on their own risk/reward profile {a subject not part of this series} and then reassess with an outlook towards three principles:

1. How has the world been reordered?

2. What are the winners and losers in my portfolio?

3. What steps can I take to lower the cost basis of that part of my portfolio I wish to keep?

The first step of reassessing the investment world post-market crash is also beyond the scope of this series but this is what I believe. Market crashes almost universally signal the end of an era. Sometimes it signals the change of investment leadership. Sometimes it signals a re-ordering of the social or political world. It is usually impossible to immediately understand what that re-ordering will look like. For instance the "Dot.com" bust in 2000-01 signaled the end of a nearly decade long out performance of technology stocks. Similarly Great Britain left the gold standard in 1931. It's doing so and the subsequent decline in world stock market prices signaled in retrospect a changing of the international political guard. This would not be fully recognized until the end of World War II. What we do know is that there will be winners and losers as the world changes. It is our responsibility to search these out for our clients. I would also note that almost every market crash-including our current situation-has at least been followed by some kind of rally where performing this readjustment is often possible.

Finally there is the issue of lowering cost basis. We have chronicled in past articles in this series the reasons for doing this in taxable accounts. First $3,000 of net capital losses can generally be deducted against ordinary income. This can be carried forward into the future. Second net tax losses can generally be carried forward to offset taxable gains in future years. Given the voracious need by governments at all levels for income and given that there is no current indication that these rules will be changed, then it is important to try and shield future gains from governmental confiscation.

This lowering of cost basis can be done in two different ways. One method is to exchange similar but not identical securities. For instance a growth oriented mutual fund carried at a loss on an investor's books can be sold and a similar fund from a different mutual fund family could be bought. Since these investments are not the same security they generally do not run afoul of the wash sale rule which we discussed previously. One caveat here {and again remember that I am not a tax advisor!} is that to me the rules on similar but not identical securities are somewhat opaque. I do not often recommend this strategy and I would strongly suggest you consult your personal tax or financial advisor before carrying out this strategy .

The second {and our preferred method for harvesting tax losses} is to either purchase or sell parts or the whole of a security, hold it for 30 days and then repurchase or sell out that same investment. Here the rules for establishing losses are pretty ironclad. Also so not as to run afoul of the code, my general rule is to wait one additional day before purchasing back or selling the security. Below, I'll give you a general example of how this works. There is more to this strategy but for this post a general example should suffice. Again consult with your tax advisor if you want a more thorough understanding of these rules.

100 shares of security "ABC" was purchased on 03.03.07 at a price of 57. It currently trades at 29. Investor A reviews the security and decides that it is still a good investment and one he wants to keep it as part of his portfolio. He buys another 100 shares on 7.01.09 at that 29 price. He must then wait 30 calendar days or by my rule 31 calendar days. He then sells 100 shares of "ABC" designating it versus purchase on that original 03.03.07 date. Let's say he sells it at 30.{Before some of you look at the calender and notice that the 31st day which would be August 1st falls on a Saturday, remember this is for illustration purposes only. In the real world I am aware that he would have to wait until August 3rd to actually complete this transaction under my rules.}

So what have we done. Assuming the investor waits the proper period, he has booked a loss of $2,700. {57-30= 27 points. 27 points x 100 shares = -$2,700}. He still owns the original security, albeit now at a lower cost basis and he has a loss on his books that based on current tax laws he can use to his advantage going forward. Forgetting the issue of offsetting personal income, if either this year or in the future he has realized capital gains then he will be able to use this to his advantage by offsetting his cumulative losses versus these gains.

I've said in the past that nobody wants losses. However they are a part of the investment world. Above we've discussed how you can use these to your advantage in a taxable account. Tomorrow we'll discuss why I believe you should employ the same strategies in tax deferred accounts as well.

*We are covering in this series what we believe is the proper procedures regarding the application of capital losses for investors at Lumen Capital Management, LLC. If you are not a client of our firm you should either do your own homework or consult with your own investment advisor before implementing any of these strategies listed in these posts. Also you should consult your own tax professional before implementing your personal strategy for capital losses. This series is a general overview and should not be considered personal tax advice of any kind. Please note as well that tax laws could change in the future which could impact the implementation of these strategies or negate some or all of the advantages of harvesting capital losses. Finally you should be aware that we have not covered all of the possible risks to which ETFs could possibly be subjected. When discussing the risks regarding ETFS, we have no knowledge nor do we make any guarantees whether some of the same issues and risks particular to equities could ultimately affect ETFs as well. Again please consult your own investment advisor or do your own homework as to the appropriateness of these investments for your portfolio You can also visit any of the popular ETF websites for a further discussion of this topic.