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Should investment decisions be clouded by tax considerations?


oec2000
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Flying Arrow brought up an interesting point about the effect of taxes on investment returns in another thread. For those with investments outside tax-sheltered accounts, this is an important issue and it would be interesting to hear how you deal with it. (Because of differences in Cdn and US taxation of capital gains - in Canada, generally speaking, all cap gains are taxed at the same rate, i.e. 50% of your marginal rate - the strategies may be different. I gather that options are treated differently too.)

 

As a starting point, I assume we all agree that, all things being equal, it is better to defer the realisation of gains to derive the benefit of interest free financing from CRA/IRS.

 

The problem starts when your investment analysis tells you to switch out of a stock on which you have a substantial gain to buy something else. I'll give two examples that I am grappling with right now. a) A preferred bought at $3.60 has gone as high as $22, a level at which I think I should sell and switch into something else with more upside. b) FFH stock bought around $250. At $375, I'm thinking of selling the common to switch into FFH LEAPs (280 or 300 call) - the idea is to reduce my downside (max downside on common is $375, max downside on 300 call is abt 100 but main thing is that LEAPs will not fall less than $1 for every $1 decline in FFH price.)

 

In the past, I have tended to make such decisions with an eye on the potential tax liability. Not sure whether there is selective perception on my part, but it seems that when I have allowed tax considerations to get in the way that I have sometimes made bad decisions.

 

 

 

 

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This is a subject which obviously affects everyone differently.  If you're a pro managing other peoples' money...well, most people care about the top line and the business is marketed with top-line results.

 

However, the fact is, if you're a citizen in the U.S. of, say, NYC or California and you're already in a high federal bracket, you're going to see your short-term gains taxed at almost 50%.  Think about that.

 

If we're talking about "risk-adjusted" returns, then if you're in a high-bracket (and whose goal isn't to be?), this issue is something to be considered for the long-term.

 

If you're doing 25% a year but it requires selling, more often than not, in under 1 year, you're looking at about a 13% after-tax return.  Can you get better than 13% per year (with less risk) by holding some terrific stalwart investments over the long term? 

 

The fact is, though, if you're marketing returns, this mostly becomes irrelevant even though it should be top of mind.  I think it mosly comes from the fact that most potential clients will have tax-deferred accounts and therefore the industry is not structured with this discussion in mind.

 

Within a couple of years (in the U.S.) dividends will once again be taxed at your marginal income tax rate while, IIRC, the long-term capital gains rate will only be rising to 20% at the federal level.  This issue is on my mind with respect to some of the high-dividend preferreds I own.

 

Given that I used to live in California and now live in NYC, these issues matter to me.  Also, it sounds like uccmal was suggesting that in Canada you can get back previously paid gains with current losses -- not so for individuals in the U.S. (though the rules are different for corporations).  It's a less important issue but nonetheless can influence things. 

 

It's an important question over a 30 year time period.  Still, I've made plenty of mistakes trying to get a long-term gain and holding too long.  But, there is a chunk of my portfolio where I buy and hold (no matter what the price does...within reason) as long as the business value appears to be growing nicely.

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b) FFH stock bought around $250. At $375, I'm thinking of selling the common to switch into FFH LEAPs (280 or 300 call) - the idea is to reduce my downside (max downside on common is $375, max downside on 300 call is abt 100 but main thing is that LEAPs will not fall less than $1 for every $1 decline in FFH price.)

 

Depends on who you pay your tax to.  Let's say you are a US investor and pay the IRS (you are not one of the many Canadians here).

 

http://invest-faq.com/cbc/trade-short-box.html

 

Then, you can take advantage of constructive sale rules:

 

For those who have read this far, there does appear to be a small loophole in the 1997 revisions that permit shorting against the box to delay a taxable event. If you have a short against the box position and then buy in the short within 30 days of the start of the tax year and leave the long position at risk for at least 60 days before ofsetting it again, the constructive sales rules do not apply. So it appears that you can continue shorting against the box to defer gains, but you have to temporarily cover the short and be exposed for at least 60 days at the beginning of each and every year.

 

 

Bottom line... this is why I don't owe tax from when I hedged my FFH position to go long ORH.  I wrote $240 strike 2011 calls to hedge against a 30% pullback and used the proceeds from the calls to buy $40 strike ORH calls which were implicitly hedged beyond a 20% pullback.  Booyah!  (sorry, Crameresque joke)  ORH goes up 30%, I sell the ORH calls and buy back the FFH calls.  I'm now unhedged FFH and I just need to keep it that way for 60 days and I'm golden (no tax on the FFH hedging).  

 

The rules may be stacked in our favor, just take advantage and don't complain  :D

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Define "clouded".

 

In my view tax considerations are an intricate part of investment decisions. They inform the decision. They don't cloud it.

 

Selling an attractive asset, taking a big tax hit, and buying another asset that is only slightly more attractive does not make alot of sense. If you're in the highest tax bracket the alternative needs to be meaningfully more attractive on a risk adjusted basis. But everyone here knows that. Do we all practice it?

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Quite frankly, If you have something that rises to your estimate of its worth then it makes alot more sense to sell, take your tax hit, and move on.  Taking the chance of riding something back down is far more costly.  Been there done that!

 

 

 

 

 

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However, the fact is, if you're a citizen in the U.S. of, say, NYC or California and you're already in a high federal bracket, you're going to see your short-term gains taxed at almost 50%.  Think about that.

 

50% is certainly high enough to make taxes matter!  :'(

 

I live in Canada where capital gains (no distinction between short and long term) are taxed at about 22% max. (I'm guessing the long term gains rate in the US is similar.) At these lower rates, I feel the decision is tougher. I've done some calculations to illustrate the tradeoffs (I've assumed 18% pretax returns and a 22% tax rate):

 

Period IRR IRR
(in Yrs) Sell Yly Hold Difference
5 14.0% 14.9% 0.9%
10 14.0% 15.7% 1.7%
15 14.0% 16.2% 2.2%
20 14.0% 16.6% 2.6%
25 14.0% 16.9% 2.8%
30 14.0% 17.0% 3.0%

 

It can be seen that the buy and hold strategy results in a significant difference only over very long holding periods. For periods shorter than 10 years, the advantage is only about 1.5% or less. So, it boils down to a question of whether investment decisions made without the burden of tax considerations can more than offset this 1.5% difference. (Remember also that my example assumes quite punitively that we turn-over the entire portfolio every year in one case and have absolutely no turnover until the end of the period in the other case.

 

Bottom line... this is why I don't owe tax from when I hedged my FFH position to go long ORH.  I wrote $240 strike 2011 calls to hedge against a 30% pullback and used the proceeds from the calls to buy $40 strike ORH calls which were implicitly hedged beyond a 20% pullback.  Booyah!  (sorry, Crameresque joke)  ORH goes up 30%, I sell the ORH calls and buy back the FFH calls.  I'm now unhedged FFH and I just need to keep it that way for 60 days and I'm golden (no tax on the FFH hedging).  

 

The rules may be stacked in our favor, just take advantage and don't complain  :D

 

But this is not quite foolproof because of the 60 day exposure, right? Anyway, unless someone else knows better, this option is not available to us poor folk in Canada.

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Quite frankly, If you have something that rises to your estimate of its worth then it makes alot more sense to sell, take your tax hit, and move on.  Taking the chance of riding something back down is far more costly.  Been there done that!

 

 

Not sure I agree entirely Al. Take FFH. I've had some wicked rides up and down over the past 5 years, particularly since I've been using leverage. I've had 50% swings representing some significant $$ amounts. Had I been a perfect market timer and sold at the top only to buy in at the bottom I'd be wealthy beyond my dreams. That's easy to say and do with hindsight but much harder at the time.

 

Instead, I've taken the dips as an opportunity to load up. In many cases I've sold common near the bottom and bought leaps to enhance returns. As a result, each of my successive rides up has gone to higher heights.

 

I realize I'm talking about a concentrated portfolio of FFH, and that throughout this time I have never felt it has risen to my estimate of its worth, however I feel the experience is worth noting.

 

My strategy has taken the "Patience of Job" and "Patience bordering on sloth" to execute however I'm extremely pleased with the results and will eventually add my numbers to this thread when I get around to the figuring. I assure you that throughout this my convictions have been tested beyond what I ever thought.

 

I guess I'm a little stuck on Buffet's favorite holding period (forever). Even if FFH rises to 1.3 or 1.5x book, I'm not sure I'll sell and take the tax hit. As long as I feel the jockey is performing and future returns on capital will be there I will have trouble selling and celebrating with a cheque to Revenue Canada...

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Period IRR IRR
(in Yrs) Sell Yly Hold Difference
5 14.0% 14.9% 0.9%
10 14.0% 15.7% 1.7%
15 14.0% 16.2% 2.2%
20 14.0% 16.6% 2.6%
25 14.0% 16.9% 2.8%
30 14.0% 17.0% 3.0%

 

It can be seen that the buy and hold strategy results in a significant difference only over very long holding periods. For periods shorter than 10 years, the advantage is only about 1.5% or less. So, it boils down to a question of whether investment decisions made without the burden of tax considerations can more than offset this 1.5% difference. (Remember also that my example assumes quite punitively that we turn-over the entire portfolio every year in one case and have absolutely no turnover until the end of the period in the other case.

 

 

Let's add the $$ to your table assuming we start with $100k.

 

5 years

14.9 $200,263

14 $192,541

Difference $7,721

10 years

15.7 $429,866

14 $370,722

Difference $59,144

15 years

16.2 $950,806

14 $713,794

Difference $237,012

20 years

16.6 $2,157,600

14 $1,374,349

Difference $783,251

25 years

16.9 $4,958,642

14 $2,646,192

Difference $2,312,451

30 years

17 $11,106,465

14 $5,095,016

Difference $6,011,449

 

At 15 years the difference is a quarter million. At 30 years its six million....

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At 15 years the difference is a quarter million. At 30 years its six million....

 

I'm not disputing that the effect is signifcant over long periods. The practical question is what is likely to be the average holding period for most of us  - even for buy & hold investors, I suspect the average portfolio holding period is likely to be closer to 5-10 years (10-20% annual portfolio turnover) than 30 years (3.3% turnover).

 

My point is that the compensating factor - that of higher returns that can be achieved through better "tax-free" investment decisions - could materially narrow the gap. (Of course, I'm making the assumption that our investment decisions would be better if we were not distracted by tax issues). So, it also depends on how much we can improve returns this way - a couple of % points makes up the difference.

 

One more factor is the possible benefit of reduced volatility of returns as pointed out by Uccmal. The implication is that lower after-tax returns might to some extent be compensated by lower volatility.

 

The example you gave of your FFH strategy is more relevant to the debate between buy & hold vs market timing and not to this discussion because, as you pointed out, its price has never risen to your estimate of its worth. For the purposes of this discussion, the question of whether to sell FFH would arise only if you felt that FFH had become overvalued and you could, for argument's sake, switch to a still undervalued ORH. Would you not do the switch, which makes sense from an purely investment point of view, simply because of the tax hit?

 

As for Buffett's philosophy of "holding forever," my take on Buffett is that while he has his broad principles, he is not dogmatic and will do contrary stuff if it makes good sense (e.g. silver, the Br real, BYD). Besides, didn't he use to do a lot of short term merger arb stuff in the early days to enhance returns?

 

Even if I sound like I'm on the side of ignoring taxes, I'm really still an agnostic and am conflicted. That's why I started this thread. I was hoping to hear of the experience of others and what they have learned from it.

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Taxes are a factor in any intelligent decision, BUT too often taxes will out weigh common economic sense.  I have been doing taxes since 1965.  Too many folks only look at the tax effect and don't look at their long range plans.  For most people (I doubt if there are many on this board who fit in this category) long range planning is about six months down the road.

Most make decisions based on the fact that they read and hear that the rich don't pay taxes, so they don't want to pay taxes.  They hear about tax free exchanges and insist that they do one even if they don't want "like kind " property.  Two years later they come back and say, "Why did you let me do that?" 

GOOD DECISIONS must be based on solid economic facts, of which only one factor is the tax effect.

jmho

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