As the year rapidly draws to a close, you can probably use some capital losses to offset capital gains realized after the recent run-up in stocks. But you may not have any viable stock losers in your portfolio that you want to give up at this time.
Fortunately, you can still salvage some tax benefits if you own municipal bonds (“munis”) that have been underperforming. But you’ll have to move fast.
Strategy: Swap muni bonds for other munis in the secondary market. Then you can use the loss from the swap to offset capital gain income (plus up to $3,000 of ordinary income). If you handle things right, you could walk away with a higher-yielding bond.
Although corporate bonds may also be swapped in this manner, the marketplace for municipals is known to be more active.
Here’s the drill: A bond swap is actually a simultaneous sale and acquisition. This means you sell a bond that’s showing a paper loss and, at the same time, buy a different bond with similar investment characteristics (e.g., the same face value). When the swap is complete, you’re essentially in the same investment position as before the swap, except now you’re showing a current tax loss.
Icing on the cake: The bond acquired in the swap could carry a higher interest rate than the bond that was traded away (see box below).
Unless you’re a sophisticated investor, you may need an investment pro to help you navigate the bond marketplace. Traditionally, the end of the year is the optimal time for muni bond swapping. But the longer you wait, the more difficult it will be to find replacement munis. So start scouting out the available options right now.
However, watch out for one potential tax trap. If you exchange bonds that are substantially identical to one another, you may not be able to deduct the loss because of the wash sale rule. The “wash sale” rule prohibits someone from realizing a tax loss if a substantially identical obligation is reacquired within 30 days of the sale.
Tip: To be on the safe side, exchange bonds of different issuers. If you swap bonds from the same issuer, make sure that there’s a difference of at least five years in maturity dates and a difference of yield to maturity of 1% to 2%. That should be sufficient to protect you.