What Is a Tax Swap?
A tax swap is a method of recognizing capital losses by selling losing positions and then buying companies within similar industries that have similar fundamentals using the funds from the sales.
A tax swap may also referred to as a tax shift or tax-loss harvesting.
Understanding Tax Swaps
Tax swap involves selling stocks at a loss and immediately buying an equivalent position in a similar, but not identical, company or industry. The capital loss that ensues from the sell transaction is tax-deductible, and can be used to offset any capital gains to reduce an investor’s tax liability. Consider an investor, Smith, who holds 700 shares of Transocean Ltd. (NYSE: RIG) which he bought for $15.80 per share a year ago. The stock is now trading for $7.30 per share. To deduct this loss on his tax returns, he must sell the shares to realize a capital loss which, in this case, will be ($15.80 - $7.30) x 700 = $5,950.
The crystallized losses help to reduce Smith’s tax liability after creating a tax swap. If Smith believes Nvidia Corporation (Nasdaq: NVDA) is a good long-term investment, he can use the proceeds from his sale of RIG to purchase NVDA shares. Assuming the shares are trading for $65.00, Smith can buy $5,950/$65 = 91 shares. In effect, Smith deducts the capital loss on his tax return while he remains invested in a similar security.
Wash Sale Rule
The investments swapped should be similar enough that the investor has the same risk exposure and investment purpose as before. At the same time, the securities must not be so similar as to be effectively identical from the perspective of the Internal Revenue Service (IRS). The IRS prohibits taxpayers from deducting losses on the sale of an investment if the same security is purchased 30 days before or after the sale, a tactic known as a "wash sale". Wash sales, to be specific, occur when an investor sells an asset in order to realize a loss, but simultaneously repurchases the same asset, or substantially identical security, within 30 days of the sale. If a sell and buy security transaction is considered a “wash” by the IRS, the investor would not be allowed any tax benefits.
Basically, wash sales are illegal, whereas tax swaps are allowed. Investors can circumvent the IRS wash sale rule and utilize tax benefits of capital losses by selling securities that they are losing money on and buying others that have very similar characteristics.
While the example of a tax swap shown above uses stocks, tax swaps are mostly done with bonds. When an investor engages in a bond swap, they are simply replacing a bond in their portfolio with another bond using the sale proceeds from the longer-held bond.
Bond swapping is a strategy usually done by investors holding individual bonds at a loss. To realize a tax benefit, a bondholder will swap bonds close to year end by taking a loss on the sale of a depreciated bond and buying a new bond of the same or similar duration but higher coupon. The investor can write-off the losses from the bond they sold to lower their tax liability, as long as they doesn’t purchase a nearly identical bond as the one sold within 30 days of selling the previously held bond. Generally, a wash sale can be avoided by ensuring that two of the following three characteristics of the bond are different: issuer, coupon, and maturity.
Limitations of Tax Swapping
Tax swaps can only be done with individual bond or stocks. Index funds or bond funds cannot be used for this strategy. For instance, swapping the Vanguard S&P Index Fund for the Fidelity S&P Index Fund would be disallowed by the IRS as both funds will be deemed to be substantially identical.
Tax swapping exposes an investor to basis risk since the stock being sold and the stock being purchased are typically not identical and will react to different market factors individually.