Now is the time for investors to concentrate on doing bond or tax swaps to enhance their investment positions. A bond swap is simply the selling of a bond that either has a profit or a loss and replacing it with a similar bond. Most bond swaps are carried out in municipal bonds. There are many reasons for doing such swaps, but aside from the investment consideration, the main reason is the legal avoidance of income tax.
Some basic ideas must be established when dealing with the tax advantages of doing bond swaps. First, a long-term or short-term profit or loss depends on the length of ownership. Any bond owned longer than one year is considered long-term, while shorter than a year is considered short-term. The holding period for a municipal bond begins the day after the trade date and ends on the execution date of the sale order. In setting up a gain or a loss, a gain is established on settlement date and a loss is established on the actual trade date of the sale. Bond swaps may be conducted at any time during the year. Swaps for losses may be executed as late as the last business day of the year for use against that year's taxes. As mentioned above, gains are controlled by settlement date and must be completed no later than the customary five business days prior to the last business day in the year.
Gains and losses may be used to offset one another. Consequently, long-term capital losses may be used to offset long-term capital gains -- dollar for dollar. For example, if an investor sells a stock or a bond or a piece of real estate that he or she has owned longer than a year and obtains a $10,000 profit or gain, it is a long-term gain. If during the same year the investor owns municipal bonds that, when sold, would create a $10,000 long-term loss, then that loss may be used to completely offset the $10,000 long-term gain.
A long-term capital loss may also be used as a deduction against ordinary income, but only up to a ceiling of $3,000. However, it takes $2 of long-term losses to create $1 of offset against ordinary income. Consequently, to reach the $3,000 limit, it would be necessary to incur $6,000 of losses. On the other hand, short-term losses may be used on a dollar-for-dollar basis as an offset against ordinary income, but only up to the $3,000 ceiling. Losses in excess of the ceiling may be carried over into the next year.
In doing tax swaps, at least two ky features of a bond must be changed in the new security. That could be a different coupon, maturity or name of issuer. If you like a particular bond, you may sell it for a loss and buy back the same bond, but only after 30 days has passed. If a substantially similar security has been purchased within 30 days before or after the date of the sale, the Internal Revenue Service could disallow the loss as a wash sale.
This year, for the first time in several years, investors have profits in both stocks and bonds. Consequently, investors may now offset their newfound profits with losses that they may still have, especially in their municipal bonds. Remember that the maximum capital gains tax rate is now 20 percent.
The Treasury will offer a two-year note on Wednesday, Oct. 20, in minimum denominations of $5,000. They should return around 10 percent.