Every year, millions of Americans file their 1040s and end up having to pay taxes; even after all possible deductions have been taken. Many are able to itemize, while others are eligible for dependent care credits, or above-the-line deductions for their retirement plan contributions. But those who have enjoyed short-term market gains or other investment income often end up being penalized harshly, especially if they have no losses to offset against them.
But taxpayers that own municipal bonds may be able to use those assets to generate capital losses without altering the overall allocation of their assets. This is a common strategy used by many brokers and investment consultants who have clients that have substantial capital gains, or other reportable investment income to declare on their returns. The swapping process itself is fairly simple. Let's assume that an investor owns a municipal bond and the market value is less than the purchase price. The investor has a loss on paper.
Let's assume that the investor is able to sell this bond and buy another bond of the same rating and similar characteristics, such as rate, term, and call features, so exchanging one bond for another will seldom affect the composition of the investor's portfolio. But this exchange effectively allows the investor to declare the sale of the old bonds at a loss, while maintaining portfolio integrity. For example, assume that a bond investor bought 10 public school bonds at par (which is listed as a price of $100) when the school originally issued them. This means that his original investment amount was $10,000.
Now, a year and a half later, interest rates have risen, and the price of the bonds in the secondary market is now $92 per bond. The broker who sold him the bonds will find 10 other municipal bonds from a similar issuer with similar features and 'swap' or exchange them within the portfolio. The replacement bonds may well be trading at a loss as well, but this is largely irrelevant, as the new bonds will vary in price, the same as the old bonds. But the investor will be able to declare a long-term capital loss of $800 on his tax return, as he bought the original bonds for $10,000 and sold them for $9,200.
If you own municipal bonds you may have a possible opportunity each year to cut your senior tax.
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