Tax swaps involve selling a declining stock and buying a similar but higher priced stock to generate a loss for tax purposes. While legal, there is a risk involved if the original stock rises or the new stock declines too much.
Tax swaps are strategies that involve the sale and acquisition of two different but similar securities. A tax swap is usually conducted as a means of using existing tax laws to realize a loss that can be applied to the overall tax obligation for a given tax period. As such, tax trading is a legitimate means of managing taxes so that the individual or entity creates a lower tax burden for the period.
The process for creating a tax exchange is relatively simple. First, the investor will identify a stock within the current portfolio that has been in decline. This rate of decline must bring the current market price of the stock below the price originally paid by the investor.
Second, the investor will identify a security currently offered for sale. This new stock must be similar to the stock that will be sold, but cannot be different shares of the same stock. The purchase price of the new security must be higher than the sale price of the old security.
By selling the declining stock and buying a similar but higher priced stock, and making both transactions in the same tax period, the investor generates a loss that can be used when tax time comes. Such creation of a loss for tax purposes, when conducted in accordance with applicable investment laws, is considered perfectly lawful.
While the process of a tax swap looks attractive on the surface, there is an element of risk involved for the investor. First, the original stock could reverse its current trend and begin to rise again, perhaps exceeding its original purchase price. This would mean that the investor would not receive the benefit of the increase, as he no longer owns the stock.
Second, the newly acquired stock could quickly go into a downward spiral, creating a greater loss than the investor had hoped to make. If the loss is too big, it could spell financial trouble for the investor. As a result, the main purpose of tax trading is defeated, and the investor has to engage in damage control.
Smart Asset.
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