A tax swap is an investment strategy usually designed for municipal bond portfolios. It is designed to allow you to take a tax loss in your portfolio while at the same time adjusting factors such as credit quality, maturity, etc. to better meet your current needs and the outlook of the market. A tax swap can create a capital loss for tax purposes, can maintain or enhance the overall credit quality of your portfolio, and can increase current income.
It’s important to note that tax swaps are not for everyone. And as always, you should consult with a tax professional before making any investment desicion that is designed to produce tax benefits.
Example
Here is an example of a hypothetical tax swap. I have not factored accrued interest to keep the calculations fairly simple.
Current Bond – You will sell this bond to generate a capital loss.
$10,000 par value “ABC” Tax Free bond, A rated, with a coupon of 4.70%. maturing 09/01/03 originally purchased for $10,000 (100) but with a current market value of only $9030 (90.30).
Replacement Bond – The bond you will buy to replace your current bond. $10,000 par value “XYZ” Tax Free bond, AAA rated, with a coupon of 5.20% maturing 12/01/12 The current selling price of this bond is $8724 (87.24)
Sell "ABC" Bond $9030.00
Buy "XYZ" Bond $8724.00
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Difference: $306.00
The tax swap accomplished the following. First, you received $306.00 cash. Second, you upgraded the credit quality of your single-bond portfolio from A to AAA. Third, you generated a capital loss of $970.00 (original purchase price minus the selling price). Fourth, you’ve increased the bond’s maturity and coupon, so its duration will be greater. This swap will increase the portfolio’s sensitivity to interest rate changes, which may or may not be what the investor had in mind. In particular, it might be not appropriate for a short-term investment. If the bond is held to maturity, then no risk is assumed other than default risk. (Although unrealized value would change wildly, and perhaps that’s taxable in some circumstance).
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Contributed-By: Bill Rini