Taking Advantage of Market Declines

The silver lining in the recent market declines is you might be able to use tax strategies to recover some losses.

We’ve been fortunate that the losses in our recommended in-vestments have been very modest. But you probably own assets beyond our recommended portfolios, and might have losses from a recommended investment if you bought at the wrong time. If so, consider some of these strategies.

The most-frequently-used strategy is to sell the losers held in taxable accounts and deduct your losses. When you sell an investment for less than your tax basis (usually the purchase price), you’ve realized a tax loss. You can deduct that loss dollar for dollar against any realized investment gains you have for the year. When the losses for the year exceed gains, the first $3,000 of the excess loss can be deducted against your other income. Any excess losses can used in future years the same way.

Of course, selling to take a loss eliminates your exposure to that asset. You’ve lost the diversification and the chance to participate in any bounceback rally.

 You could sell an investment and buy it back, but the tax law discourages an immediate re-purchase. Buy an investment within 30 days of selling it, and you won’t be able to deduct the loss now. The loss is added to your basis of the newly-purchased shares, and you get the tax benefit later when you sell it. In other words, under this “wash sale” rule your deduction of the loss is deferred until you’re completely out of the investment for more than 30 days.

With markets so volatile now, you probably don’t want to lose your exposure to an asset for the 31 days or longer the tax law requires. A lot of the loss could be recovered in a rally in that time. You have to consider an alternate strategy.

Suppose you recently began following our “hedge fund” portfolio of mutual funds. To take a worst case, let’s say you purchased Third Avenue Value in early April at around $54 per share. Recently the fund was around $44 per share. That’s about an 18.5% loss.

You could sell the shares, and deduct the loss. You have several options for staying exposed to equities in the portfolio during the waiting period. You could move the sale proceeds into Wintergreen fund. It’s held value much better than Third Avenue Value in the downturn but still is likely to fully participate in any turnaround. You could buy another deep discount value stock mutual fund, but you won’t find a perfect match for Third Avenue Value. That’s why I recommend Wintergreen. After more than 31 days have passed (be sure to check for redemption fees), you can sell the extra Wintergreen shares or the other fund you bought and buy back into Third Avenue Value.

You can’t buy a fund that’s “substantially similar” to the one you sold. That’s not a problem with Third Avenue Value, because there isn’t one that would be considered substantially similar. This rule shouldn’t be a problem with any actively-managed mutual fund, but it could be a problem with an index fund.

The benefits to the strategy are that you locked in the tax loss deduction, and you still retain the market exposure. You’ll fully participate in any recovery while still deducting the loss on this year’s tax return.

Suppose the market continues to decline. After more than 31 days have passed you can sell all your Wintergreen shares (or whatever other new fund you purchased), lock in that tax loss, and use the proceeds to repurchase shares of Third Avenue Value.

Before taking a tax loss or buying a replacement fund, review all the potential costs. Look for redemption fees, trading fees, and others. If there are costs or limits involved, you probably need a loss of 10% or more to justify incurring the costs of taking a loss.

There are other strategies to consider when markets are down.

When you were on the fence for converting a traditional IRA into a Roth IRA, review the decision. With your IRA’s value down, the tax cost of converting now is lower. You can convert at today’s value and have all the money in a tax-free Roth IRA when the portfolio recovers.

We discussed the pros and cons, and ins and outs, of converting to a Roth IRA in past visits. You can find those discussions in the IRA Watch section of the Archive on the members’ web site at www.RetirementWatch.com. You also can find versions of them in the new subscribers reports sent to many of you the last couple of years.

Those who converted traditional IRAs to Roth IRAs earlier this year or last year also should reconsider. You have the option of reversing that conversion (known as a recharacterization) up to Oct. 15 of the year following the conversion if you filed the tax return for the conversion year on time. When the converted IRA substantially declined in value, you probably don’t want to pay taxes based on the pre-conversion value. To avoid that you can recharacterize and consider converting later.

Use your recharacterization with care, because your right is limited. Once you’ve recharacterized, you can’t reconvert until the later of 30 days and the end of the taxable year have passed. That means if you recharacterize now, you won’t be able to convert again until January 2012. You don’t want to recharacterize unless the loss is substantial and you believe a market turnaround is unlikely in coming months.

Estate planning also comes into play during a downturn. It’s a great time to make any gifts you were planning. You can give away more shares of stock or mutual fund shares than you could have a few months ago and still qualify for the $13,000 annual gift tax exclusion. Wealthier people can give away more shares and qualify for the lifetime $5 million exemption. When you believe the asset is good for the long-term and likely to appreciate at some point, a market low point is a good time to give it.

One exception is to avoid giving property in which you have a substantial paper loss. When you give property, the donee’s basis is the lower of your cost and the current market value, so they would take current market value as the basis when you’re holding the property at a loss. No one would be able to deduct the loss.

Otherwise, to reduce the size of your estate and transfer wealth to loved ones at the lowest tax cost, make your gifts or other transfers of property when markets are down.

RW October 2011