Using Options to Increase Your Clients’ After-Tax Rate of Return - Continued
Some clients are emotionally attached to a particular security and despite your recommendations, they refuse to sell the position. If the position is held at a loss, explain to your client that the tax code allows for a step-up in basis when inheriting appreciated stock, but penalizes beneficiaries for inheriting stock held at a loss by imposing a step-down in basis to the current fair market value. By demonstrating how no one will receive the economic benefit of the loss, you can motivate your client to sell the position. Furthermore, you will add a great deal of value to the client engagement by postponing a significant portion of the taxation on their portfolio so that heirs can receive a full step-up in basis on a larger pool of assets. By communicating this value to heirs, you build a relationship with the next generation and increase the likelihood of retaining advisory control over the account.
Now that we have identified some of the hazards, how does one go about harvesting a loss? The simplest answer is to sell the position outright, wait thirty-one days and then repurchase the position at the prevailing market price. While immediately receiving the benefit of the loss, you will forgo any participation in the underlying security during the harvest period. Accordingly, the position may rise in value over those thirty-one days. So how can we maintain our participation in the underlying security?
One could double the investment in the position, wait thirty-one days, sell the original lot and then recognize the loss. By doubling up, exposure is maintained during the harvest period, but at a substantial cost. The amount of capital at risk is significantly increased and any additional losses will be magnified by a factor of two. Furthermore, this position will wreak havoc on the portfolio’s asset allocation.
Now consider the purchase of long-dated equity call options on the security. Just as before, you would then wait thirty-one days, sell the original lot to recognize the loss, then wait an additional thirty-one days to decide whether to maintain the option position or swap back into the underlying security. This method requires significantly less capital and mitigates the severity of any additional losses. In addition, long-dated deep in-the-money calls will have large deltas, experiencing very little time decay over the harvest period. Nevertheless, more capital is placed at risk and just as in our previous example, there is an element of uncertainty as thirty-one days must elapse before harvesting the loss.
Is there a way to maintain participation in the security and not expose additional capital to risk? The IRS will allow you to recognize a loss and then immediately sell a put on the underlying security, provided that the put is not deep in-the-money. Therefore, one can sell the security and immediately recognize the benefit of the loss. Moreover, the sale of an at-the-money put will provide premium income that will subsidize transaction costs, while maintaining exposure to the underlying security. To avoid a wash sale and mitigate the risk of early assignment, you could sell a put with at least forty-five days to expiration. The proceeds of the security sale should be placed in a low risk, interest-bearing vehicle that will generate a collateral yield, which will augment the total return over the harvest period. If the underlying security were to rally substantially, there would be an opportunity cost associated with this strategy. However, if the underlying security rises modestly, remains at the same level or declines, you will have given your client the benefit of recognizing the loss in the current tax year, while providing income that insulates the position from further declines.
As you can see, options are not one-dimensional. Consequently, advisors who feel that options are confined to the realm of speculative investments are missing an opportunity to add significant value to their client relationships.
Rudy Aguilera is a founding principal with Helios, an independent fee-only Registered Investment Advisor that offers objective investment counsel free from industry and product affiliations. Helios works closely with advisory firms so that they may expand their suite of services to include low-cost, diversified, tax-efficient portfolios that exhibit less volatility than traditional equity investments. You can reach Mr. Aguilera by sending an email to firstname.lastname@example.org
1 Arnott, Robert, Andrew Berkin, and Jia Ye. “Loss Harvesting: What’s It Worth To The Taxable Investor?” Journal of Wealth Management. 3. 4. (Spring 2001)
2 McWilliams v. Commissioner, 331 U.S. 694 (1947)