At this time of the year, prudent investors typically turn to using tax losses on their bond holdings as an offset to short- or long-term capital gains or ordinary income. But this year the Tax Reform Act of 1986 has changed the rules.
According to information from the brokerage firm of Smith Barney, Harris Upham & Co. Inc., there are several key changes that have altered the treatment of capital losses and gains.
The first, the brokerage says, was the elimination of the capital gains exclusion. Under the previous law, the maximum capital gains tax was 20 percent; beginning this year capital gains are now taxed at a specified rate.
Starting in 1988, long-term capital gains will be taxed at the same rate as ordinary income. Since short-term capital gains are already taxed at the same rate as ordinary income, beginning in 1988 the major differences between short- and long-term gains will be history.
In 1988 the maximum marginal tax rate will be similar for both forms of income -- 15 percent for low-income brackets and 28 percent for most investors, but 33 percent for investors in the "surtax" bracket. This year the maximum tax rate on ordinary income is 38.5 percent, while the maximum tax rate on long-term capital gains is 28 percent.
Formerly, net short-term losses could be offset against ordinary income on a dollar-for-dollar basis, up to $3,000 a year. Only 50 percent of net long-term losses could be offset, so it took $6,000 in net long-term losses to offset the maximum $3,000 ordinary income. Under the new law, up to $3,000 in short- or long-term losses may be offset against ordinary income on a dollar-for-dollar basis, with the unused net losses carried forward into future years.
There are several important implications from these changes, according to Smith Barney.
First, the value of long-term losses has been increased. "The increase in the maximum tax rate on capital gains to 28 percent also increases the benefit of taking losses to be offset against those gains," the brokerage says. "Remember, capital losses can only be used against ordinary income up to $3,000 a year. If, however, an investor has substantial capital gains, he or she may receive the maximum benefit in the present year by taking capital losses up to the full amount of capital gains incurred, plus $3,000."
Next, the maximum capital gains tax will be higher next year. Therefore, investors who expect to be in the 33 percent surtax bracket next year may wish to take capital gains this year.
Finally, the minimum tax effect of capital gains is eliminated. Notes Smith Barney, "Under the new law, there is no minimum tax impact from taking capital gains. This change is important for municipal bond investors, since municipals may be unattractive for an investor who pays the minimum tax, rather than the regular tax."
Having mentioned the new ground rules, here are other reasons for tax swapping: to upgrade the credit quality of a portfolio, to sell smaller positions and place the proceeds into fewer but larger positions, to diversify holdings, to increase income and to take advantage of discrepancies in the market -- for example, selling a bond that may be high-priced and purchasing a cheaper bond. But the main reason for swapping is to legally take advantage of tax savings by utilizing tax losses against capital gains or ordinary income.