Tax-optimized management of your muni portfolio

In “The True Value of Your Muni Portfolio,” I discussed other ways to quantify the investor-specific value of a taxable portfolio. Market value just isn’t appropriate because liquidating the portfolio would have tax consequences and the liquidation value would subsequently differ from market value. Instead of market value, I advisable the “tax-optimized” value, which is the upper of the after-tax selling price and the holding value of the safety.

Let’s calculate the tax-efficient value of a 10-year 5% bond purchased two years ago at 113.3 and whose current tax basis is 111. Today, eight years before maturity, the market price is 106. Selling at 106 would end in a long-term capital lack of 5 points and subsequently a tax savings of 1 point at a 20% tax rate, leading to an after-tax sale proceeds of 107. This exceeds the holding value of 106, and subsequently the tax-efficient value today is 107.

Should you sell this bond at 106 and take the 5 point loss, or must you proceed to carry it?

There are two investment strategies: sell and reinvest, or do nothing. In the event of a sale, the after-tax proceeds are reinvested in a 5% 8-year bond, increasing the par value of your holding by an element of 107/106.

Let’s calculate the tax-smart performance of the 2 strategies one yr later under two scenarios. What happens if rates of interest fall and the worth rises from 106 to 110? What happens if the worth falls to 102?

The tax-efficient portfolio values ​​for the 2 strategies are shown within the attached tables. Note that the tax basis is dependent upon the strategy: for the Do Nothing strategy, based on the unique purchase price of 113.3, it’s 109,782. For the Sell and Buy Back at 106 strategy, it’s 105,352, and the notional value of the investment has increased by an element of 107/106. The tax-efficient returns, measured by IRR, rely on the ultimate tax-efficient portfolio values ​​and the coupon interest received through the yr.

Scenario 1: Price rises to 110 within the third yr

If the worth rises to 110, the return based on selling within the second yr is 8.414%, and without selling it’s 7.426%. The difference of about 1% is on account of the chance cost of not recognizing the lack of capital at the tip of the second yr – once the worth rises, that chance could also be lost endlessly.

Scenario 2: Price falls to 102 within the third yr

When the worth drops to 102, the performance of the loss-making sell strategy remains to be barely higher: 1.589% versus 1.466%. The difference is partly on account of the upper interest income from reinvestment under the loss-making sell strategy and in addition is dependent upon the amortization of the idea, which corresponds to the several purchase prices.

Realizing a loss and reinvesting has an extra profit: it restarts the short-term clock. Long-term losses are deductible at 20%. Short-term losses, or those occurring in lower than a yr, may be deducted on the much higher rate of 40%, assuming there are offsetting short-term gains. Assuming that is the case, the lack of 3,384 (106,346-102,962) would end in a tax savings of 1,354 if the market price fell to 102. The tax-efficient final value would rise to 104,316 and the return from 1,589% to 2,223%.

In summary: . It identifies selling opportunities by comparing the after-tax proceeds from the sale to the worth to be held. Selling and reinvesting are particularly effective when the worth subsequently improves, as there may be a chance cost related to doing nothing. When the worth subsequently declines, restarting the short-term clock provides a chance to capture short-term losses at a high effective tax rate, further improving performance in comparison with doing nothing.

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