Tax swaps involve selling a declining security and purchasing a similar but higher-priced security to create a loss for tax purposes. While legitimate, there is risk involved if the original security reverses or the newly acquired security declines too much.
Tax swaps are strategies that involve the sale and acquisition of two different but similar securities. A tax redemption is generally done as a means of using existing tax laws to realize a loss that can be applied to the general tax liability for a given tax period. As such, the tax swap is a legitimate means of managing taxes for the individual or entity to create a smaller tax burden for the period.
The process for creating a tax swap is relatively straightforward. First, the investor will identify a security within the current portfolio that has been in decline. This rate of decline should take the current market price for the security below the price originally paid by the investor.
Second, the investor will identify a security stream offered for sale. This new security must be similar to the security to be sold, but cannot be different shares of the same security. The purchase price of the new security must be greater than the sale price of the old security.
By selling the declining value and purchasing a similar but higher-priced security, and completing both transactions in the same tax period, the investor creates a loss that can be used when tax time arrives. When done in accordance with applicable investment laws, this creation of a loss for tax purposes is considered perfectly legitimate.
While the process of a tax swap appears appealing on the surface, there is an element of risk involved for the investor. First, the original security could reverse the current trend and begin to rise again, perhaps exceeding the original purchase price. This would mean that the investor would not receive the benefit of the increase, since he or she no longer owned the collateral.
Second, the newly acquired security could shortly spiral downward, creating a greater loss than the investor expected to achieve. If the loss is too big, it could spell financial trouble for the investor. As a result, the main objective of the tax swap is defeated and the investor has to engage in damage control.
Smart Asset.
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