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Tie a bow on municipal bond swaps

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in Small Business Tax,Small Business Tax Deduction Strategies

Municipal bonds, known as “munis” by experienced investors, are likely to be at a premium at the end of 2012. Not only do they produce income free of federal and sometimes state and local tax, the income isn’t subject to the new 3.8% Medicare surtax.

When your circumstances dictate it, you might take things even one step further.

Strategy: Swap underperforming munis for other munis in the secondary market. Then you can use the loss from the exchange to offset capital gain income plus up to $3,000 of ordinary income.

If you handle things right, you could even walk away with a higher-yielding bond for the future.

Here’s the whole story: A muni 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 exchange is complete, you’re essentially in the same investment position as before the swap, except now you’re showing a current tax loss. What’s more, the bond acquired in the swap may carry a higher interest rate than the bond that was traded away.

Example: You own a Blue State muni 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 capital gain from your transactions in 2012. So your broker arranges a swap of the Blue State bond for a Red State muni. The Red State bond also has a face value of $10,000 and a current value of $8,000. However, as opposed to the Blue 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, as the Red State bond matures, you must pay tax on the $2,000 accretion in value that occurs while you hold the bond. But that’s in the future, and you might be able to swap bonds again before then, so the tax hit could be postponed even longer.

Tip: Don’t wait any longer to pull off a swap. The market is expected to be crowded this year-end.

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