It is that time of year again!

by Wayne Ferbert on November 23rd, 2012

No, we are not talking about Black Friday. We are referring to the end of the year which means TAX PLANNING season. We are not experts on taxes or tax planning but you don’t need to be an expert to understand some of the basic rules about harvesting tax gains and losses.
It is time to look for gains or losses in your portfolio to harvest in order to minimize your tax bill come April of 2013. With a little over a month to go, you should be looking at your realized and un-realized gains/losses. It is smart to plan for this with some time to spare.
Step 1: Determine whether you have a total realized gain or loss on your taxable portfolio(s) for the calendar YTD 2012.
If it is a loss, look at whether it is over $3,000 – the most you could claim before you would need to carry forward some of the loss. If it is under $3,000, then you are probably ok for the year. If it is over, then you probably want to look for some gains to harvest that can be offset by the losses.
If you have a gain, then you should look for losses that you can realize that can offset the gains. This is especially important if the gain you have is short-term in nature. Short-term gains (held for less than 1-year) are taxed at your normal income tax rate. These are the most important to off-set.
You should look at your un-realized gains/losses and identify some potential gains or losses that you can consider to optimize your tax bill now.
Step 2: Pulling the trigger on the right trades to take your gains or losses
After you have some potential targets for taking gains or losses, you need to ask yourself this question: are you ready to close this position because you no longer believe in it? Or because you want to harvest the gain/loss for tax reasons?
If you no longer believe in the stock or ETF, then close the position and never look back. This should be a regular exercise for you anyway as a Buy & Hedge investor.
But if the reality is that you still want to hold the stock, then you need to work within the rules for wash-sales to harvest the gain/loss. These rules exist to keep you from selling a position to harvest a loss in the short-term with the purpose of off-setting it against a taxable gain.
Effectively, if you sell a position to harvest a loss and purchase the identical ETF/stock within 30 days of the sale, you will have established a wash-sale. The IRS would say that you did not effectively sell it and you will not be allowed to take the loss in that tax year.
If you still want to effectively own the stock/ETF but want to harvest the loss, you could consider selling the stock/ETF and purchasing a deep in-the-money call option on the same stock/ETF. This position will behave very similar to the stock. If it is a deep in-the-money call, it should have a high delta – meaning that the value of the call will move close to $1 for every $1 the stock moves.
You could hold this call option for 31 days after selling the stock to harvest the loss, and then close the deep ITM call and re-purchase the stock again. This technique helps you avoid the wash sale rule while capturing just about all of the move in the stock price as if you actually owned the stock.
But because the call option is technically a different investment vehicle than the stock, it does not trigger the wash-sale rule. Your risk in owning the call is slightly different than the risk of owning the stock and so the IRS recognizes that risk as a different position and does not invoke the wash sale.
I would recommend looking at March ‘13 or April ‘13 deep ITM calls for your substitute option. The December or January options would have too much time decay over the next 30 or so days to be a good stock replacement. If you use the March or April options and sell by early January, you should still retain most of the very little time value you pay to enter that option.
This is a nice technique for harvesting losses to offset gains without having to exit your exposure to the stock. You have created synthetic exposure to the stock that has a slightly different risk profile - but moves almost dollar for dollar like the underlying stock/ETF.
TIPS to consider when harvesting gains/losses at year end:
TIP #1: Don’t forget that any positions you own in your portfolio on index future options (like SPX or NDX) must be marked at year end. That means you must take the gain or loss on the position as of Dec 31st – as if you closed the position even though you have not closed the position. Remember to consider that when determining the total realized/unrealized gains or losses you expect for the year.
TIP #2: Before you harvest a loss and hold the option for the next 30 days, make sure to look at the ex-dividend date for the stock/ETF. If the stock is going to go ex-dividend in the next 30 days, consider waiting until after that date to execute this strategy. Many stocks and ETFs have an ex-dividend date that will occur in late December. The option holder will not get paid the dividend - as only the stock holder gets paid the dividend. So execute the trade to move to the option AFTER it goes ex-dividend. Then wait the 30 days in to January and move back in to the stock.

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