Tax Losses and (Temporary) Cuts

We take an inordinate amount of pride - nay, a fiendish diabolical pleasure - in playing little games that one-up the financial system.  For example:

A few years back (8 years ago, to be precise), Bank of America had this thing going - any debit card purchase would get rounded up to the nearest dollar, with the difference being transferred over to your checking account.  Apparently they wanted to try and help people save really tiny amounts of money?  So say your morning coffee costs $2.85.  You would see $3 come out of your checking account and $0.15 get transferred over to your savings account.

As an added incentive, Bank of America offered to match your savings “round ups” for the first six months, up to something like $500: free money!

So.  Yours truly was in business school at the time, and taking the T everywhere, which cost…$2.00 a ride back then if memory serves?  Anyway, the point is, instead of loading even-dollar amounts on the Charlie Card, I would load the minimum amount possible, to get the biggest savings round up and therefore the biggest match from BofA.

(For those curious, five cents is the minimum amount you can load on a Charlie Card at any one time, and you can only do four add-value transactions in a 1-hour window...so yes, multiple times a day I would trek to the T station and load five cents on to my card four times.  By the time I had enough loaded for an actual T ride, I had gotten a free $38 from Bank of America.  And yes, of course I got the full $500 from them before the 6 months was up.)

A little bit obsessive?  Undoubtedly.  Slightly absurd?  Perhaps.  But nothing quells that giddy little flame of joy that springs up at the thought of taking advantage of the system.

And now, fast forward to the present and the end of the calendar year presents another opportunity for us to quasi take advantage of the system on your behalf: tax loss harvesting.

When investing, you don’t have to pay taxes until you actually realize profits (that is, sell the position).  You could have made $100,000 in the market this year and would owe $0 in taxes on it if you didn’t sell anything.  The flip side of profits, is of course, losses.  Not all investments work out as you would hope.  The IRS allows you to use losses to offset income, but again, they have to be realized losses.

So you want to sell positions that are at a loss, but what if it’s a position you feel strongly about holding on to, or you don’t want to sit on cash and miss out on any potential gains after you sell? The IRS mandates that to realize a loss, you can’t buy the security back (or a substantially similar security) within 30 days.  The trick is, that “substantially similar” wording is wide enough to drive a Mack truck through.  No - two Mack trucks, with a Jean-Claude Van Damme straddling them.

The S&P 500 and the Russell 1000 are both indices that track the US Large Cap market.  There’s a huge amount of overlap between them (95%, if we had to guess a number), and the correlation between the two of them is approximately 0.99.  But!  Because they are different indices, they are not substantially similar securities.

So if your S&P 500 position is at a loss, you can sell it and immediately buy an equal amount of the Russell 1000, meaning the value of your portfolio hasn’t changed at all and the investment exposure of your portfolio hasn’t changed at all, and yet you have magically generated losses to offset your income and reduce your tax bill.  How much is this worth?  Let’s do math:

Say you start with a $100,000 portfolio - 10 positions at $10,000 each.  After a year, 9 of those positions are up an average of 10% but one of them is down 30%, so your overall portfolio has gained $6,000 ($90,000*10% - $10,000*30%).  Now, sell the position that is down for $7,000 and immediately buy $7,000 of something very similar (but not EXACTLY similar!).  You still have the $106,000 in your portfolio (that you don’t owe any tax on yet), but you ALSO have $3,000 of losses that will subtract from any income you earn over the course of the year.  For anyone earning over $38,000 in a year, that is $3,000 you DON’T have to pay at least 25% tax on, meaning it saves you somewhere between $750 and $1,200 in taxes depending on your tax bracket.  Boom!

Now, it’s not quite free money in the vein of the Bank of America free money example that started this newsletter (for technical reasons that we would happy to get into if you’re interested), but since $100 today is worth more than $100 a year from now, yeah, there’s a little bit of free money involved.  So just sit back, relax this holiday season, and let us game the system for you.

When a Tax Cut Isn’t

Unless you’ve been hiding under a rock lately (in which case we’re totally jealous), you have probably heard that there’s finally a unified tax bill up for vote in Congress this week that will, barring something desperate and/or unforeseen, likely become law before the end of the year.

Our personal opinion is that the tax bill, in a word, sucks.  It’s right up there with Citizens United in terms of blatant anti-individual corporate favoritism.  Let’s recap:

• Corporate taxes cut from 35% to 21%
  
• Individual taxes streamlined and cut similarly from a max of 39.6 to a flat 25%....oh wait, no, not at all.  Still seven (7) different tax brackets.  Instead of 10, 15, 25, 28, 33, 35, 39.6 the brackets are 10, 12, 22, 24, 32, 35, 37, with no expansion of the brackets (and in fact contraction of a couple...that’s right, your marginal tax rate might actually go UP if you’re making $160k!).  Oh yeah, and these lower rates revert back to the higher rates in 2025, so….big whoop.
  
• Standard deduction doubled, but offset (occasionally more than offset) by loss of personal exemptions.
  
• Preferential tax rates on passive income (if you have an actual “job” and contribute to the growth of the economy no tax break for you!  But if you’re just collecting passive income, congratulations, here’s a tax break.)
  
• Caps on the mortgage interest deduction
  
• Caps on deductions for property/state/local taxes 

So.  A blatant corporate money grab that, in our view, will only serve to exacerbate the growing economic inequality that is underlying the polarization of our country.  Because trickle down stimulus has worked so wonderfully this last decade.  Oh yeah, and there’s also that bit about the deficit expansion this will cause that will have to be offset in the future by cuts to entitlement programs and increased taxes, which will disproportionately hit the people whose 2% tax breaks are going away in a few years.  Brilliant.

Okay, so on the one hand we fundamentally hate almost everything about this tax bill.  On the other, what’s done is (will be) done, and the prospect of an entirely new system to game on your behalf is exciting.  Here are some things to consider:

• There’s a $10,000 cap on state/local/property tax deductions in the new bill.  If you pay more than that, consider prepaying property taxes (if allowed).  DON’T prepay state/local taxes, there’s a provision that makes those nondeductible this year.  (The only exception to the above is for quarterly estimated taxes.  The Q4 payment is due in January, but you can pay it this quarter and potentially deduct it on this year’s taxes.)
  
• Consider bringing as many itemized deductions forward into 2017 as possible.  This includes charitable donations, medical expenses, etc.  The standard deduction is doubling next year, so your itemized deductions will have more of an impact this year.  Doubly so because they will be deductions against a higher tax rate (unless you make around $160,000-$190,000 as an individual).
  
• If you have any control over the timing of income you receive, you might be better off getting income on January 1st rather than December 29th.
  
• If you get any sort of rental income, consider setting up an LLC and owning the rental properties through the LLC instead of under your individual name (if you haven’t already).  This could let you take advantage of the preferential treatment for passive income.
  
• The deductibility of interest on home equity loans is going away, so take a look at refinancing to consolidate your existing mortgage and home equity loan into a new mortgage which might offer greater deductions.
  

Those first three bullets need to be looked at in the next 10 days, before the year ends.  The last two are things to consider going forward, if your situation warrants.  In any case, there’s lots of conditional language in those suggestions because they are things to consider in light of your individual tax situation - there’s no simple black and white across-the-board recommendations.  Because that kind of beneficial tax reform is apparently a bridge too far.  Multiple bridges, in fact.  But as Yosemite Sam said, “If you can’t beat ‘em, join ‘em.”
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Speaking of joining, we hope everyone has a wonderful holiday season closing out 2017 with friends and family and comes back next month rejuvenated and excited for the new year.  We know we're certainly looking forward to sharing another year with you all, so until then - Merry Christmas, Happy Holidays, and Happy New Year!