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Unpacking Tax Management

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Rey Santodomingo, CFA

Managing Director, Investment Strategy (emeritus)

How deftly do asset managers navigate the US tax code? This article unpacks five important elements of tax-efficient management to help determine whether they’re making the most of tax efficiencies.

When an asset manager says they “manage investments tax efficiently,” what do they mean? Many asset managers claim to use a tax-efficient approach, but there are a wide variety of approaches. The US tax code is complex. Investors may be familiar with the many different ways the sale of a stock can be taxed, but the complexity of the code means there are optimal and suboptimal ways of navigating it.

These five basic tools help investment managers build a comprehensive tax-management strategy:

Defer the realization of gains. A manager may choose to sell an asset with an embedded gain, resulting in a tax obligation. If the manager chooses to hold the security instead, the tax is deferred. This deferral is similar to receiving a zero-interest loan from the government in an amount equal to the liability. As more time passes, the impact of the tax deferral compounds. For investors who anticipate being subject to a lower tax bracket in the future (such as soon-to-be retirees), the value of this loan can be significant. In some cases, the investor can defer payment of the liability indefinitely. For example, capital gains are never recognized when securities are gifted to charity or if their cost basis is stepped up at the taxpayer’s death.

Manage the holding period. Capital gains from the sale of a security are taxed as ordinary income unless the investment is held for longer than 12 months. Long-term capital gains qualify for a tax rate lower than the ordinary rate. Whenever possible, managers should avoid incurring short-term gains.

Harvest losses. Selling an asset whose market price has fallen below its purchase price results in a realized capital loss. These losses are advantageous to taxpayers because they can offset realized capital gains: Short-term losses can offset painful short-term gains, and long-term losses can be applied to friendlier long-term gains. If no gains are available to offset in a given tax year, the investor can carry the loss forward indefinitely. While many investors harvest losses only in December, this strategy is far more valuable if it’s done opportunistically throughout the year as part of ongoing routine portfolio management.

Tax affects performance, so we pay close attention

Pay attention to tax lots. Tax-aware managers generally use highest in, first out (HIFO) tax-lot accounting to reduce the tax impact of the sale of a security. Generally, this is the right approach; in some cases, however, HIFO may not be the desired method. Investors might reduce their tax burden by choosing to sell a slightly lower-cost-basis short-term tax lot that’s more advantageous than a higher-cost-basis long-term lot. A manager who can thoughtfully identify the ideal tax lots to trade under differing circumstances can create benefits for the investor, particularly those who need to generate cash flow from their investments or have charitable-giving plans. 

Avoid wash sales. When an investor repurchases a security within 30 days of its sale, any loss realized can’t be used to shelter capital gains. Tax-efficient managers should take this into account when they’re considering rebuying a recently sold security. It’s important to know these risks exist and to take steps to mitigate them when possible.

The bottom line
Does every asset manager use all these tools? These steps are not always easy to follow, and it’s best to apply them in a coordinated fashion. Managers who can pull all these tactics together can deliver highly tax-efficient investment performance. Managers who don’t could be leaving some tax efficiency on the table.

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.