As the year draws to a close, you can still salvage tax benefits if you own underperforming municipal bonds (“munis”).
Strategy: Exchange the munis 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 usually more active.
Here’s the whole story: 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.
Example: How a swap pays off
Let’s say you own a Central State municipal bond you purchased for $10,000. The bond’s current value is $8,000; it will mature in 18 years and it has a 4.5% interest rate.
Currently, you’re showing a net $2,000 gain from your earlier capital gain transactions in 2011. So your broker arranges a swap of the Central State bond for a Coastal State bond. The Coastal State bond also has a face value of $10,000 and a current value of $8,000. However, as opposed to the Central State bond, it matures in 20 years and has a coupon rate of 5%.
Results: First, the $2,000 capital loss from the sale part of the swap wipes out your capital gains tax for the year. Second, you benefit from a small increase in annual income. Instead of earning $450 of tax-free interest each year, you now receive $500 tax-free.
Of course, when the Coastal State bond matures in 20 years, you must pay tax on the $2,000 gain as ordinary income. But that’s a long way off. And you might be able to swap bonds again before then, so the gain could be postponed even longer.
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 harder it will be to find replacement munis.
Caution: Watch out for one potential tax trap when you swap munis. 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 an investor from realizing a tax loss if a substantially identical obligation is reacquired within 30 days before or after the loss sale.
To be on the safe side, you should exchange bonds of different issuers.
Tip: 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 in the yield to maturity of 1% to 2%.
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