The following analysis is based on “Tax Smart Portfolio Assessment and Benchmarking,” Andrew Kalotay’s forthcoming article in portfolio management journal, and Kalotay “Trade municipal bonds with tax efficiency,” from Financial Analysts Journal.
Let’s say you have a portfolio that consists of tax-exempt municipal bonds. How do you determine its value?
|Basic||coupon||ripening time||The date of purchase||Purchasing price||current basis||current price|
|$100,000||5%||eight years||two years ago||113.3||111.0||106.0|
|$100,000||2%||eight years||two years ago||100.0||100.0||95.0|
If you liquidate the portfolio, the proceeds will be $201,000. But these bonds are in a taxable account – the bonds should not be held in an IRA account – and the sale has tax consequences.
The current tax basis for a bond bought at 5% for 113.3 is 111. Selling for 106 will result in a long term capital loss of $5,000. At the applicable 20% tax rate, the sale will reduce your taxes by $1,000. So, for you The real value of 5% Mons is $107,000.
Let’s apply the same analysis to the 2% bond. Selling at 95 would result in a loss of $5,000 and a tax saver of $1,000. So, on a post-tax basis, the 2% moni is due at least $96,000 for you.
But munis deduction is more complicated, because the so-called minimum tax effect must be taken into account. De minimis refers to the deduction tax treatment. The gain from the “unlimited” big discount is taxed at vesting as ordinary income, at about 40%.
For a 2% bond, the buyer at 95 has a 2-point tax liability on a 5-point gain. On a present value basis, 2 points eight years from now equals 1.7 points today. This future tax cost is reflected in today’s rate of 95 – without it, the 2% s would be worth more than 1.7 pips, or 96.7!
Buyers of 2% munis at 95 are compensated fairly for the cost of future taxes. But what is the value of these bonds to you, considering you bought them at par?
Since the tax basis is 100, you don’t pay tax when the bond matures at the 2% rate, so the present value of your cash flow is 96.7. This exceeds the sale price after tax of 96 by 0.7 points! In dollar terms, the value contract of your 2% mons is $96,700. Since the value of the reservation exceeds the after-tax sale proceeds, it would be wrong to sell just to save on taxes.
In short, the real value of your portfolio is $107,000 + $96,700 = $203,700, which exceeds the market value of $201,000 by $2,700. The bottom line is that on a post-tax basis, the value of the portfolio may be very different from its stated value. Selling at a loss can be helpful, but be careful with the mons deduction: You can save in taxes but not enough to compensate you for the higher holding value. The goal is to maximize after-tax value, rather than to save on taxes.
Viewing your portfolio through a tax-smart lens will open your eyes to its true after-tax value.
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All posts are the opinion of the author. As such, it should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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