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Tax Loss Selling?

EACH YEAR-END, TAX-SENsitive investors scramble through portfolios, looking for investment losses to offset realized gains. But a tax-avoidance mentality can blur objectivity in the wealth-creation process.

Before taking action, investors should consider a few issues that should drive the selling decision and the potential impact of current market anomalies.

For most investors, every transaction should be driven by its value aspects. Only the rare investor can consistently outperform a value strategy by "gaming" the market.

Investors make purchase decisions -- that is, they judge value -- based on assumptions about earnings, cash flow, assets, management quality, etc. When selling investments, investors should consider the same factors. Specifically, the time value of the tax savings should be weighed against any unrealized value in stock prices.

Consider a hypothetical stock that was purchased at $50 and that is now trading at $30. Because of a deteriorated company outlook, the stock is realistically worth only $40. But because of some misinterpretation of value or a market disturbance, it has traded off another $10.

If the investor sells the stock, he or she will net about $35 -- a $5 tax saving (a 25 percent capital gains tax on a $20 loss), plus $30 in proceeds.

But consider this alternative: The investor waits a year to sell. The company's outlook has not improved, but the stock has traded back to a reasonable value of $40. The sale nets $42.50 -- a $2.50 tax saving (a 25 percent capital gains tax on the $10 loss), plus $40 in proceeds.

The assumption that by selling a year earlier, the investor would enjoy the tax saving a year earlier doesn't hold. The investor would have to earn 50 percent on the $5 tax saving to equal the $7.50 earned by waiting for the market to realize the true value of the stock.

Justification for selling a significantly undervalued, security might lie in the purchase of an equally undervalued security. Such a tax swap would most likely occur in a homogeneous industry or type of security. Trading a regional bank stock for another regional bank stock or a bond for another bond of similar characteristics are two examples. IRS "wash sale" rules prevent a swap of substantially identical securities.

Understanding current market issues requires a historical perspective. The Standard & Poor's 500 was up an average of 10 percent annually from 1960-94. However, it was up an average of 29 percent annually from 19 9599. The technology-heavy Nasdaq 100 was up 83 percent in the six months ended March 31, 2000, alone!

Therefore, for much of 2000, it is probable that many investors continued to realize capital gains on greatly appreciated positions. That is especially true for mutual funds, since they typically turn portfolios faster than individuals do and they often liquidate positions in sloppy markets to meet shareholder redemptions.

In the fall, many mutual fund managers realized that 2000 was likely to be a poor-performing year in light of a slowing economy, rising fuel and energy costs, and a weakening European currency. Year-end capital gains distributions would be hard for shareholders to digest if they were coupled with negative returns.

It is believed that tax loss selling by mutual funds was, therefore, vigorous and often at fire-sale prices as funds managers raced to minimize realized gains before closing the books in October. Stock prices tumbled. Realistically, most of that money should have re-entered the market by now ... except for a certain market-shaking disturbance in Florida.

Because of the unique market conditions over the past few months, the logic seems even more compelling this year that decisions on tax-loss selling should be made through the art of valuation rather than as a continuation of a seasonal practice.

If market disturbances continue to separate pricing from value, it may best serve the wealth creation process for investors to reconsider the timing of tax-motivated transactions.

Andrew A. LaGrone, CFA, CPA, is a portfolio manager and analyst with Lathrop Investment Management Corp. of Little Rock. There are many applicable tax, market and investment security issues outside the scope of this article. All investment decisions should be made with consideration of other investment resources and after consultation with investment and tax advisers.
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Title Annotation:investor taxation information
Author:LaGrone, Andrew
Publication:Arkansas Business
Article Type:Brief Article
Geographic Code:1USA
Date:Dec 18, 2000
Words:698
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