What Professionals Must Know to Tax-Manage Bonds

What Professionals Must Know to Tax-Manage Bonds

Ravi Agrawal, AAMS

Executive Summary

• Bond tax swaps can be an effective way of enhancing returns over a buy-and-hold strategy, but a comprehensive understanding of newer tax laws is essential to the outcome.
• Harvesting the capital gains of bonds has a high success rate, while harvesting the losses has a moderate success rate. Gain harvesting works best when interest rates have fallen sharply, the remaining maturities are short to intermediate, the premiums are high, and the issues are taxable. Loss harvesting is more successful when interest rates have risen sharply, the remaining maturities are long, the discounts are large, and the issues are municipals.
• Higher income tax rates and lower capital gains rates favor gain harvesting and diminish the benefits of loss harvesting.
• Harvesting capital losses is a common practice when interest rates rise. But this technique can be counterproductive, especially with shorter maturities, as additional taxes are often payable following a tax swap.
• The method of accounting for premiums and discounts is also important to success. Premiums of taxable bonds should be amortized annually and deducted against interest. Market discounts that are taxed are better deferred until maturity.
• Unbeknownst to some, all bonds bought at market discounts to issue price owe ordinary income taxes, even municipals.
• Under optimum accounting methods, discount taxable bonds have an after-tax edge over premium taxable bonds, and premium tax-exempt bonds have an edge over discount tax-exempt bonds.