Journal of Portfolio Management,Magazine for financial analysts
Suppose you might have a portfolio consisting of two tax-exempt municipal bonds. How do you identify its value?
| Nominal value | coupon | Time to maturity | Date of purchase | Purchase price | Current base | Current price |
| 100,000 US dollars | 5% | Eight years | Two years ago | 113.3 | 111.0 | 106.0 |
| 100,000 US dollars | 2% | Eight years | Two years ago | 100.0 | 100.0 | 95.0 |
If you were to liquidate the portfolio, the proceeds could be $201,000. But those bonds are in a taxable account—munis should not be held in an IRA—and selling them has tax consequences.
The current tax basis of the 5% bond purchased for 113.3 is 111. Selling it for 106 would lead to a long-term capital lack of $5,000. At the present tax rate of 20%, the sale would scale back your taxes by $1,000. Therefore, the true value of the 5% munis is $107,000.
Let’s apply the identical evaluation to the two% bond. Selling at 95 would lead to a $5,000 loss and a $1,000 tax savings. Therefore, the two% munis are price $96,000 to you after taxes.
However, things are more complicated with discount munis since the so-called de minimis tax effect have to be taken into consideration. De minimis refers back to the tax treatment of the discount. The gain from a big non-de minimis discount is taxed as unusual income at around 40% when it becomes due.
With the two% bonds, a buyer at 95 would have a tax liability of two points on the 5 point gain. On a gift value basis, 2 points in eight years are price 1.7 points today. And these future tax costs are included in today’s price of 95 – without them, the two% bonds could be price 1.7 points more, or 96.7!
The buyer of the two% munis at 95 will probably be fairly compensated for future tax costs. But how much are these bonds price to you, considering you obtain them at par?
Since your tax basis is 100, you can pay no taxes when the two% bonds mature, and due to this fact the current value of your money flows is 96.7. This exceeds the after-tax selling price of 96 by 0.7 points! In dollar terms, the worth of your 2% munis is $96,700. Since the holding value exceeds the after-tax proceeds from the sale, it might be a mistake to sell only for tax savings.
In summary, the true value of your portfolio is $107,000 + $96,700 = $203,700, which exceeds the market value of $201,000 by $2,700. The conclusion is that the after-tax value of a portfolio will be very different from its reported value. Selling at a loss will be helpful, but watch out with discount munis: chances are you’ll save taxes, but not enough to offset the upper value of the shares. The goal is to maximise after-tax value, not to avoid wasting taxes.
When you take a look at your muni portfolio from a tax perspective, you will notice its true after-tax value.
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