Thursday, August 30, 2007

Tax Loss Harvesting in the Mutual Fund and ETF Context

This is to introduce the idea of tax loss harvesting with mutual funds and ETFs. I'm not a tax professional and you're fully responsible for the consequences when following this practice.

1. What is tax loss harvesting?

Basically sell your underperforming funds to realize short-term capital losses and get tax deductions in your tax return (a discount to your loss).

2. What is the risk with tax loss harvesting?

Market risk. If the fund recovers after you sell your shares, you lock in your losses and miss the gains.

3. How do you avoid the risk?

Don't lose your market position. Instead find a replacement fund to hedge the price movement risk. However, there is a catch: the IRS has a "wash sale rule" to specifically disallow fully hedged tax loss harvesting. Basically the wash sale rule says you can't claim a loss on a stock/fund sale if you bought a substantially identical stock/fund within 30 days before or after the sale. It's not clear how IRS interprets "substantially identical" in the MF/ETF context. So this is a currently a grey area.

4. How do you hedge the risk without using "substantially identical" funds?

There are a lot of funds that are not substantially identical in terms of holdings. But when it comes to price movement, they are closely clustered.

For example, are FXI/PGJ/GXC/MCHFX substantially identical? I don't think so, because their holdings are so different. Yet their price movements are almost the same.

Another example, are VFINX/VLACX/VTSMX substantially identical? This one is harder to tell, since VFINX is a dominant subset of VLACX, which is then a dominant subset of VTSMX. However, I think it's safe to say that VIVAX or VIGRX is not substantially identical to VFINX/VLACX/VTSMX, yet their price movements are similar.

5. Is tax loss harvesting worth doing?

Absolutely. This is one of the very few ways you can improve upon the market average return. Let's do some math here.

Marginal income tax rate: 28%
Long-term capital gain (LTCG) tax rate: 15%

For each $100 loss you claim, you get $28 back from tax return. If you replaced your fund with another one, you basically lowered the cost basis by $100 for your market position. So you will eventually pay, hopefully, the LTCG tax on this $100 difference, which will be $15 (assuming tax rates don't change).

The best thing is that you can defer this $15 LTCG tax as far as you want, when the currency is seriously devalued. For example, if you hold the fund for 10 years while you invest the $28 tax refund in something that gives you a 5% after-tax annual return, your $28 will grow to 28*1.05^10 = $46, and you only need to pay $15 back in the end.

The saving is even more if you currently have a high state tax (e.g. California's 9.3%) and there is chance that you will move to a low tax state in the future.

6. How to implement tax loss harvesting with MFs/ETFs?

Implementing it systematically is pretty hard. Some of the difficulties are:

1) Mutual funds don't support tax lot sales, so you can't sell your high cost basis shares only.
2) Most brokers don't let you select tax lots of ETF sales either (they usually assume FIFO), but it appears that you can do it in the tax return, which is probably very troublesome.
3) If the price does move up during the 30 day period after you swapped your funds, you're stuck with the replacement fund if you want to take advantage of the LTCG tax rate. So you have to make sure your replacement fund also matches your long term investment goals.
4) There is commission costs and bid/offer spreads if you trade ETFs.

That said, the recent market downturn provides a perfect opportunity to effectively implement tax loss harvesting, especially for these who bought new funds near the market peak (me included).

7. Conclusion

Tax loss harvesting is a useful strategy, especially in the MF/ETF context, where you can be well hedged against the price movements during the wash sale blackout period. However, one has to play the game very carefully and one mistake could wipe out the gains (e.g. you do accidentally buy a
substantially identical fund, even in your retirement account). Again, this is a grey area of IRS. Only play the game if you know what you are doing and can afford the consequences.

8. References
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