What to do about low-basis stock.As the Dow Jones industrial average Dow Jones Industrial Average The best known U.S. index of stocks. A price-weighted average of 30 actively traded blue-chip stocks, primarily industrials including stocks that trade on the New York Stock Exchange. hovers near record highs, some investors may find themselves "stuck" in a portfolio concentrated in a single low-cost-basis stock. The investor might be a retired executive of a public company who received the stock as compensation over many years. Or, the stock may have been received as a gift from a relative or acquired in a merger or acquisition. Alan D. Glatt Glatt may refer to:
1. A person making investment recommendations in return for a flat fee or percentage of assets managed, known as a commission. 2. For mutual fund companies, it is the individual who has the day-to-day responsibility of investing and monitoring the cash and in the private client services group at Morgan Stanley  To comply with Wikipedia's , the introduction of this article needs a complete rewrite. and Co. in New York City New York City: see New York, city. New York City City (pop., 2000: 8,008,278), southeastern New York, at the mouth of the Hudson River. The largest city in the U.S. and Darya B. Allen, CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , a tax specialist for Morgan Stanley's private client services group, explain some of the options CPAs can offer clients for handling this problem. While owning a substantial amount of any stock should not be a problem, the "opportunity cost" of maintaining a portfolio concentrated in a single stock - what you forgo by letting the funds remain undiversified - must be considered. Even if the stock has appreciated, is it smart to allow the bulk of a client's net worth to be exposed to the market forces that can affect a single stock? A client who owns 400,000 shares of one stock, for example, can see his or her net worth change by $400,000 with only a $1 change in the stock's price. Such investors also may be missing the higher returns they could earn through diversification. The most straightforward strategy is simply to sell the appreciated stock. However, clients will then have to pay taxes on the capital gains. This may be the wisest strategy depending on the client's holding period and tax bracket Tax Bracket The rate at which an individual is taxed due to a particular income level. Notes: Each income class is taxed at a different level. Generally, the more you make the more you are taxed. . But although many would rather wait for a possible capital gains tax cut, they still don't want to leave their portfolios exposed to market fluctuations. Some advisers are suggesting that clients seek alternatives to free up cash now and realize the gains later. TRUSTS Low-basis stock often is held in trust - for example, a trust funded with gifts of stock over many years. Trust assets can present a particular problem because trustees are inclined to invest conservatively and are reluctant to sell assets that require the payment of taxes. Trust assets often remain in the same stock that created the trust for generations because trustees fail to consider the best aftertax investment alternatives available. Trusts are taxed at a top marginal tax rate Marginal Tax Rate The amount of tax paid on an additional dollar of income. As income rises, so does the tax rate. Notes: Many believe this discourages business investment because you are taking away the incentive to work harder. of 39.6% on income in excess of $7,650. While a trust is responsible for tax payments, trustees are responsible for the growth and preservation of the trust assets. In many states and under some trust agreements, trust assets can be managed as "prudently" as an individual investor would manage his or her own portfolio. (This is known as the "prudent man" rule.) Yet trustees who invest their own assets in balanced portfolios - carefully managed at yearend to match gains and losses - will leave trust assets in the single stock of an industry in decline or let large loss positions remain open rather than sell the stock. SOLUTIONS It is difficult, and sometimes costly, to diversify stock holdings without realizing gains. Yet the potential returns can make it worthwhile. For example, a retired executive who had a large part of her compensation paid in stock may be anxious to diversify out of an industry that had a difficult year and faces hard times in the future. Should she wait for a capital gains tax cut? Probably not. This same client may want to continue to own stock in her former employer but still seeks protection against the downside risk Downside Risk An estimation of a security's potential to suffer a decline in price if the market conditions turn bad. Notes: You can think of this as an estimate of the amount that you could lose on a stock or other investment. . The securities industry has devised solutions to help investors deal with such problems. Some possible strategies are * A long-term "short-against-the-box" transaction. * A swap into an index fund - a custom-tailored basket of securities traded over-the-counter or a standard index such as the Standard and Poor's Noun 1. Standard and Poor's - a broadly based stock market index Standard and Poor's Index 500, the S&P 100 or an international index such as the Nikkei index. * A "zero-cost" collar. Note: A glossary A term used by Microsoft Word and adopted by other word processors for the list of shorthand, keyboard macros created by a particular user. See glossaries in this publication and The Computer Glossary. of investment terms appears opposite. Short against the box. This popular strategy allows investors to raise cash for diversification and lock in a gain (or loss) without actually liquidating the stock. Capital gains are deferred to the following year (or forever, using a perpetual short against the box). In a short sale, borrowed stock is sold for future delivery with gain recognition postponed until the stock actually is delivered. If the short seller actually owns the stock but borrows it anyway, that kind of sale is called a short against the box. The seller can then borrow up to 95% of the short sale proceeds to diversify. In most cases the net margin interest cost is 1% to 3% of the amount of the short sale proceeds used for diversification. Interest may be tax deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes). as investment interest, depending on how the proceeds are reinvested. If the proceeds are used to acquire tax-exempt securities Tax-exempt security An obligation whose interest is tax-exempt, often called a municipal bond, offered by a country, state, town, or any political district. , the interest is not deductible. A short sale can remain open until the investor decides to deliver the stock and close the transaction. In a perpetual short sale, stock is not delivered on the sale (by the estate) until the investor dies. The completed sale is thus a realized transaction for the estate. When an investor owns a security at the time of his or her death, the heirs receive the benefit of a step-up in cost basis, generally to the market value on the date of death. If a short sale is closed after an investor's death, capital gains on predeath appreciation are not recognized. Index swap Index swap A swap of a market index for some other asset, such as a stock-for-stock or debt-for-stock swap. . Another way to defer de·fer 1 v. de·ferred, de·fer·ring, de·fers v.tr. 1. To put off; postpone. 2. To postpone the induction of (one eligible for the military draft). v.intr. tax on appreciated securities is to swap the portfolio's performance for that of an index fund through a contractual agreement with a brokerage firm. The investor gives up dividends and changes in value on the appreciated stock for the dividends, upside potential Upside potential The amount by which analysts or investors expect the price of a security may increase. upside potential The potential price or gain that may be expected in a security or in a security average, generally stated as the dollar and downside risk of another portfolio. Under current tax law, such a contract would not be deemed a sale of the existing portfolio. Equity swaps Equity swap A swap in which the cash flows exchanged are based on the total return on some stock market index and an interest rate (either a fixed rate or floating rate). Related: Interest rate swap. raise a number of significant legal issues under federal securities and commodities laws that are beyond the scope of this article. Use of these swaps may not be permitted for certain individual investors. Zero-cost collar zero-cost collar The investment position of being short a call option and long a put option for stock already owned. The premium received from selling the call option is used to pay for purchase of the put. . Investors who are simply interested in protection against market movement (with no tax deferral tax deferral The delay of a tax liability until a future date. For example, an IRA may result in a tax deferral on the amount contributed to the IRA and on any income earned on funds in the IRA until withdrawals are made. ) and who do not need diversification may be able to use a zero-cost collar. This instrument is a hedge that provides protection against market movement by locking in a floor and a ceiling on the price of a particular stock. The investor buys a put option - an option to sell stock at a specific strike price - to limit the downside risk. This guarantees the investor a specific price for the stock. Top create the zero-cost collar, the investor also sells a call option and collects the associated premium to offset the cost of buying the put option. The call option limits the stock's upside potential. As the price of the underlying security exceeds the strike price of the call, it will be exercised; the stock's value is "collared" with a put floor under the stock and a call ceiling above the current price. The option strike prices and maturities are customized to meet the investor's needs. He or she may have to post the stock as collateral for the call option. For investors comfortable with relinquishing re·lin·quish tr.v. re·lin·quished, re·lin·quish·ing, re·lin·quish·es 1. To retire from; give up or abandon. 2. To put aside or desist from (something practiced, professed, or intended). 3. a stock's potential growth and dividends in exchange for downside protection Downside Protection Generally used in connection with covered call writing, this is the cushion against loss, in case of a price decline by the underlying security, that is afforded by the written call option. at no cost, a zero-cost collar may be the best approach. NO SINGLE FORMULA In a complicated investment environment, there is no single formula for every situation. Each of the methods described above is appropriate for particular circumstances and specific investor types. In fact, certain investors may be precluded from using one or all of these strategies because of private placement restrictions, accredited investor Accredited Investor A term used by the Securities and Exchange Commission (SEC) under Regulation D to refer to investors who are financially sophisticated and have a reduced need for the protection provided by certain government filings. Also known as "qualified purchaser". limitations, affiliation with the company in question, position size or holding period. Each investor must examine carefully a strategy's risks and his or her own objectives. Additionally, investors should consult advisers to examine the ramifications ramifications npl → Auswirkungen pl and should consider their risk profiles and investment objectives. EXECUTIVE SUMMARY * Some investors are burdened with a portfolio concentrated in a single stock. Acquired as compensation, as a gift or in a merger or acquisition, the shares leave investors exposed to the market forces that can affect a single stock and force them to forgo the benefits of diversification. * While the most straightforward strategy is to sell the stock, the shares typically have appreciated - meaning taxes will have to be paid on the capital gains. Investor reluctance to take gains and a possible capital gains tax cut create a need for other strategies. * Using a short against the box - selling borrowed stock the investor actually owns for future delivery - allows investors to raise cash for diversification and lock in a gain. * An index swap also allows investors to defer tax on appreciated securities by swapping the portfolio's performance for that of an index such as the Standard & Poor's 500 or the Nikkei index. * By using a zero-cost collar, investors who do not need diversification can be protected against up-and-down market movement. GLOSSARY OF INVESTMENT TERMS Short sale. Contract for the sale and delivery of securities that the seller does not own or does not intend to make available for delivery upon sale. Short against the box. A short sale of a security an investor currently owns. Perpetual short against the box. A short sale on which stock is not delivered for an extended period of time. Put option. An option to sell a stock at a specific price and time in the future. Call option. An option to buy a stock at a specific price and time in the future. Zero-cost collar. A hedge transaction that protects against market movement by locking in a floor and ceiling on a particular stock's price. Equity swap. A contractual agreement in which an investor exchanges the performance and income of one portfolio for that of another. |
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