We only have a couple more weeks to profit from various Year-End Portfolio Strategies.
Investors looking to improve their overall portfolio returns often turn to tax-loss harvesting as an end-of-the-year opportunity. This amounts to selling some stocks or assets that have fallen in value and using the losses to help offset capital gains tax liability, reducing the overall tax bill.
In November we were telling clients that we may not have much opportunity to take these losses, but the past month has given us more options, which may prove beneficial as portfolios recover to previous highs.
How much can you actually add to your returns through tax-loss harvesting?
A recent Bank of America study found that investors can juice their returns at 1.10 percentage points a year on average, assuming a 25% tax rate. If investors are pushing it in terms of taking advantage of every tax-loss harvesting opportunity, they can add as much as 1.42 percentage points a year to their portfolio’s return.
Not surprisingly, investors can reap the most from tax-loss harvesting when the stock market is having a down year. During years when the S&P 500 yielded a negative return, this same study estimated that the average benefits of harvesting losses amount to 3.21 percentage points of additional return to an equity portfolio (assuming a 25% tax rate).
It should be noted that each individual’s tax-loss harvesting situation is highly personal. For example, investors facing high short-term capital gains, which are taxed at a higher rate, in particular, might benefit from tax-loss harvesting.
More deferral options are now available to save taxes
Another area where we are saving taxes for clients derives from a relatively new development called Opportunity Zones. Created toward the end of 2017, those who invest in certain underdeveloped parts of the country, designated as Opportunity Zones, can gain several tax advantages that may significantly improve after-tax returns. These tax incentives have been specifically designed to direct the flow of capital into areas of the United States that need it the most.
Investors who elect to reinvest capital gains into Opportunity Zones will receive the following tax benefits:
1. Deferral of Capital Gains Taxes: Capital gains (short-term or long-term) from the sale or exchange of any capital assets that are reinvested in Opportunity Zones within 180 days following the sale or exchange, will be excluded from an investor’s gross taxable income until the earlier of December 31, 2026, or the date the investor sells his Opportunity Zone investment.
2. Reduction of Capital Gains Taxes: Investors will receive a 10% step-up on the basis of any capital gains that are reinvested in Opportunity Zones, if the Opportunity Zone investment is held for 5 years prior to December 31, 2026.
3. Elimination of Capital Gains Taxes for Investments in Opportunity Zones: Opportunity Zone investors are exempt from federal taxation (the majority of states conform as well) on capital gains derived from the appreciation of their Opportunity Zone investment if the investment is held for at least 10 years.
We have been utilizing opportunity zone funds much more extensively this year with many clients showing more significant capital gains toward the end of 2021. In looking at the last six months, all the gains can be deferred into the next year to the extent that only the tax losses are left. If most of the gains for the year are from prior to six months ago, we can still benefit but keep in mind any gains from more than 180 days past will not qualify for the capital gains deferral.
Opportunities for Profit at Year-End.
Typically the biggest opportunity to profit toward the end of the year traces to the tendency of stocks sold in December to bounce back in the New Year.
Many are not aware of this bounce-back tendency, and so, therefore, miss out on the second half of this two-pronged year-end strategy. But it’s quite pronounced, as you can see from the chart below, which reports the average monthly returns in December and January of the trailing year’s worst- and best-performing stocks. To put losing stocks’ rebound in context, consider that on an annualized basis they produce the equivalent of a 55% gain in January.
There’s a catch: The IRS disallows your tax losses if, within 30 days you repurchase the stocks you have sold. It’s because of this so-called wash sale rule that we don’t have any time left this year to sell the stocks we’re holding with a loss and repurchase them by the end of December.
What if you don’t want to spend December out of the stocks you’d otherwise consider selling for tax-loss purposes? One solution is to find other securities that are highly correlated with them and to substitute these new ones during the 30-day wash-sale period. To the extent the substitutes perform as well as the original holdings, we won’t be missing out on any gains while still being able to harvest tax losses.
To illustrate, consider Exxon Mobil, which was one of 2020’s biggest losers and therefore in the crosshairs of investors looking for losses to harvest for tax purposes. A good substitute would have been the Energy Select Sector SPDR, since — as the chart below shows —the two securities are highly correlated. This high degree of correlation means that a 10% move in one security would typically mean the other would return anywhere from 9.3% to 10.75% during the same period.
This year Alibaba has been one of the year’s biggest losers and has been seeing a lot of attention from investors such as Charlie Munger and Ray Dalio purchasing significant positions in the 3rd quarter. In spite of this, the shares have continued to sell off below the 2020 pandemic lows as tax-loss selling has gained momentum. A good substitute for Alibaba would potentially be Krane Shares China Internet Fund. This correlation, at greater than 80% is also pretty strong over the last few years.
Looking at data since 1986, analysts found that stocks that saw a 10% or more loss as of late October experience a bounce from Nov. 1 to Jan. 31, outperforming the S&P 500 (^GSPC) 70% of the time. The thinking is that these “losers” are often unloaded to offset gains and thus get temporarily depressed in value.
“On a monthly basis, this strategy [of buying a basket of these struggling stocks] tends to have the highest median returns in November and January, perhaps benefitting from the rebound after the Oct. 31 deadline for tax-loss selling for mutual funds and then the rebound after the Dec. 31 deadline for regular tax filers,” analysts wrote.
This sometimes leads to a whipsawing action toward the end of the year where stocks look to the bottom in October, make significant gains in November, sell off again in December and recover strongly into the next year.
Considering Exxon Mobil and the Energy Select Sector SPDR ETF, both had lost over 50% of their value from January 1st to November 1st, 2020. In November they rallied 22% and 28% respectively and both rallied in 2021 to be up more than 50% for the year through mid-November, 2021.
High-quality companies that are temporarily down may not be fun to own toward the end of 2021, but it is very likely that these could prove to be some of the biggest winners in 2022. Picking up someone else’s discards tends to be a profitable strategy toward the end of the year, especially if much of the reason for the weakness in the stock is due to tax-loss selling. When we see the type of capitulation that sometimes transpires in these names and there are few sellers left, those buyers who stepped in when things looked the bleakest tend to do well.
Joe D. Franklin, CFP is Founder and President of Franklin Wealth Management, and CEO of Innovative Advisory Partners, a registered investment advisory firm in Hixson, Tennessee. A 20+year industry veteran, he contributes guest articles for Money Magazine and authors the Franklin Backstage Pass blog. Joe has also been featured in the Wall Street Journal, Kiplinger’s Magazine, USA Today and other publications.
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