Now that I’ve introduced the strategy and talked about the pre-tax aspects of the strategy, it’s time to move onto the tax aspects of the strategy.
Watch out for Wash Sales
The main tax rule that I have to navigate is Section 1091 which provides in relevant part:
“In the case of any loss claimed to have been sustained from any sale or other disposition of shares of stock or securities where it appears that, within a period beginning 30 days before the date of such sale or disposition and ending 30 days after such date, the taxpayer has acquired…by purchase…substantially identical stock or securities, then no deduction shall be ….”
That’s a mouthful!
However, for my purposes this simply means that I will be denied all or part of my deduction if I buy the same stock within 30 days after selling it. The tax law just wants to make really sure I sold my stock in a real sense in order for me to take the loss.
Given the strategy I’m employing, this is a really easy provision to avoid. I sell a stock and I mark it on my spreadsheet as unavailable for repurchase for 30 days. After that, I can repurchase the stock and the circle of life begins again.
Which stocks do I sell?
To sell a stock and buy a different stock, I have to determine that the benefit outweighs the detriments.
The main benefit is obviously triggering a loss that I can use to reduce the amount of my gain on my next tax return. How do I measure that benefit? The first thing to recognize is that reducing the amount of the tax is not a 1-for-1 benefit. In other words, if I save $1 on my next tax return, I have to pay $1 of tax on a later tax return (assuming no changes in tax law). For example, let’s say I have a $100 gain on my home. In my strategy, I buy stock X and Y. X has a gain of $100 and Y has a loss of $100. While my portfolio (as a whole) has neither increased or decreased in value, I can sell Y for a loss and use that loss to shelter the gain on my home. However, I am still holding X at 100 of gain. At some point, I may have to trigger that gain and eventually pay the tax. However, since I generally have control over when I dispose of X, I could theoretically indefinitely defer triggering that gain. In accounting parlance, this would involve removing a current tax liability and replacing it with a deferred tax liability (i.e., debit current tax, credit deferred tax). This is effectively like borrowing the tax saved from the IRS at an interest rate of 0%.
The question, therefore, becomes: how valuable is it to borrow from the IRS at an interest free rate? That entirely depends on (1) what you can do with the taxes saved and (2) how long you can defer the tax liability. Both of these depend on my assumptions.
With respect to (1), I make a fairly aggressive assumption. With respect to (1), I assume I can make at least 5% on the taxes saved. This is aggressive in the sense that interest rates on borrowings are currently nowhere near 5%. However, I’m guessing that I won’t plow my tax savings into a fixed income return. Theoretically, I could apply the rate of return on my strategy to the tax savings (or some other equity return), but this seems way too aggressive to me given the early stages of my strategy. I may adjust this assumption in the future but for now I’m sticking with 5%.
With respect to (2), I make a fairly conservative assumption. I assume I will defer the tax savings for only one year.* Remember that I could theoretically defer this tax savings indefinitely so one year seems kind of paltry. Again, I may change this assumption in the future but will stick with one year for now.
Therefore, I measure the benefit of the taxes saved by multiplying the taxes saved by a 5% return for 1 year. For example, if I have a $500 loss that reduces my taxes owed by $100 (assuming a 20% tax rate), the benefit of selling the stock is $5 ($100 x 5%=$5).
The main detriment of this strategy is that I incur bid-ask costs from buying and selling stock because I purchase and sell stock with market bids. The bid-ask spread is essentially the difference in price between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to sell. When I buy with a market order, I’m paying the “ask” price because that’s the best price I can get from a willing seller. When I sell stock with a market order, I’m selling at the “bid” price because that’s the best price available from a willing buyer. Because the bid price is generally lower than the ask price I anticipate I’m incurring the bid-ask cost when I buy and sell stock. I assume I’ve already incurred this cost for the stocks I own (i.e., it’s a sunk cost), so in calculating the detriment of this strategy, I calculate the bid-ask cost of the replacement stock. For example, let’s say I want to sell stock X and buy stock Y and that Y stock has a bid-ask spread of $0.02. If I want to buy 200 shares of stock, I estimate the bid-ask cost of buying Y stock is $4. I then compare this cost to the benefit I calculated above.
In addition to the cost of bid-ask spread, you may incur certain transaction fees with your broker when you buy and sell stock. I try to minimize these costs and, in fact, don’t currently incur any such costs for my trades. Therefore, these are not a factor in determining whether to buy and sell (yet).
One other detriment is that the replacement stock will not perform identical to the stock sold. However, two things. First, since I don’t have a view on any particular stock, I’m fairly indifferent as to whether the replacement stock will perform differently than the stock sold. Second, and more importantly, I’m more interested in whether the portfolio as a whole will track the S&P500. Generally, I’m betting on the fact that replacing one stock won’t affect my tracking error too much; particularly if I replace the stock with one in the same sector or, better yet, a competitor (e.g., if I sell Ford, I buy GM). This is what was alluded to in my post about trying to mimic the S&P500.
Based on the foregoing, I track the benefits and detriment on a spreadsheet that is filled with market data every minute from google finance. My spreadsheet identifies when the benefit outweighs the detriment and, if I’m at home at the time, I sell the stock for a loss and replace it with a different stock.
The results I’m giving below will be based on a notional investment of $100,000—that is, I’ve adjusted my actual amounts to fit $100,000.
I have engaged in this strategy for about 45 days. Based on a notional investment of $100,000 I’ve triggered approximately $3,800 of tax losses. Keep in mind, that I have actually made money using this strategy. My overall net gain, based on the same notional, is currently approximately $4,100 (that is, I have unrealized gain of approximately $7,900).
In my next post, I will post some additional thoughts on this strategy that didn’t seem to fit the discussion in this or other previous posts.
*Keep in mind that these tax savings are realized only when I file my tax return and offset the gain on my apartment, which is the year following the sale of my apartment.