Damian Gallina, CFA
To save taxes over a lifetime, we prefer to buy investments worth holding and then let them compound over a very long time. Deferring taxes lets our clients hold onto capital that can compound and grow. Essentially, we continue to invest money that would otherwise be consumed in taxes from more frequent trading.
Realized taxable gains were somewhat muted in 2019, although there were a few common tax triggers for our clients.
- Portfolios with Fox Corp (FOX) realized sizable gains as a result of the acquisition by Disney (DIS) that was completed in 2019. Although, requesting more of the payment in Disney shares versus cash, as permitted under the deal terms, helped to limit the tax consequences.
- Portfolios with a bond allocation tend to get skewed more heavily toward stocks when stocks outperform like they did in 2019. Rebalancing back to the original mix of stocks and bonds is meant to force discipline to sell stocks high after strong performance, or alternatively, to purchase stocks low after they drop. Rebalancing actions taken to raise bond or cash positions, especially to replenish cash for clients who make monthly or annual withdrawals, generally resulted in capital gains.
- Otherwise, limited market volatility led to a slower pace of portfolio activity in 2019. Generally, we try to buy when we perceive deeper bargains, which are more plentiful when the whole market drops taking the good down with the rest. The few new positions introduced over the course of the year including Anheuser-Busch InBev (BUD), Discovery Communications (DISCA), General Dynamics (GD), and Microchip Technology (MCHP). These were generally funded by selling other investments with smaller unrealized capital gains.
The long bull market means that many of our investors have the high class problem of sizable unrealized gains, which limits options to further manage taxable capital gains. For better or worse, there generally aren’t many positions trading at an unrealized loss for most portfolios, but there are some. Where it made sense to mitigate realized gains from 2019, we looked to do that.
For those losses to be deductible, the Wash Sale Rule requires that investors not buy the same security within 30 days either before or after the loss is realized. Assuming an investor still sees merit in a security that has declined in price, two strategies are available to harvest a loss and repurchase the investment.
1- Sell the security, and wait for 30 days to buy it back. The advantage of this approach is that it is simple and minimally disruptive. Cash for a future purchase can be available to repurchase shares after the 30-day period has passed. The disadvantage is that shares may appreciate within the 30 day period after you’ve sold, leaving you the ability to repurchase fewer shares. Because investors tend to harvest losses around the end of the year, often with the same out-of-favor sectors or securities, there is a real risk of selling at overly depressed prices.
2- Buy additional shares of the security at least 30 days before the end of year, and then sell the older high cost shares after 30 days. This approach maintains exposure to a potentially undervalued security, but requires liquidity. If cash isn’t readily available, raising it could cause tax consequences of its own. Also, additional shares in the security leave the portfolio subject to added risk of a price decline when the position size is larger.
Alternatively, investors can simply sell the security and buy a somewhat similar investment. If the similar investment rises and falls in much the same way, the portfolio stands to benefit from appreciation in price while waiting to repurchase the original investment.
Where it made sense to manage taxes for 2019, we harvested losses in oil services provider Schlumberger (SLB) and purchased iShares U.S. Oil Equipment & Services ETF (IEZ), a basket of oil service companies, including Schlumberger, that has typically risen and fallen similar to SLB shares.
The energy sector remains deeply out of favor after a steep decline in oil and gas prices that began in 2014. In commodity businesses, like energy, it is said that the cure for low prices is low prices. Lower profits have meant less investment in aging oil fields, which deplete as deposits are extracted. Historically, that underinvestment eventually curbs supply growth leading to higher prices, profits, and supports a new investment cycle. There are nuances in each of your tax situations that helps us know who this maneuver fits. We go with what we know, but it is VERY helpful when we have a copy of your recent tax return on hand. Please make sure we have yours when we ask for a copy each April!