Dave Sather's Money Maters: Squeezing Value From Losing Positions
Sept. 20, 2011 at 4:20 a.m.
By Dave Sather
This week, my students at Texas Lutheran were confronted with something all investors face sooner or later - a losing position. While their portfolio is comprised of strategies used by Warren Buffett, this market has been challenging for all.
Since "Bulldog Investment Company" was started three years ago, the TLU students have been very skilled investors. Although they have had to take their lumps with everyone else since late July they only have one troubling position.
What to do about this one position?
They could sell it. However, despite being down 17 percent on this one investment, their research indicated it was still a solid company with good prospects. They ruled out a complete liquidation.
After that decision was made, I asked them how they could squeeze economic value out of a losing position.
Andrew Kopecki, a senior from Stockdale, spoke up that you could sell out of the position and recognize the loss. He added that you could buy back in after 30 days. Andrew recognized that in order to avoid the "wash sale" rules in which the IRS disallows the tax deductibility of a loss, you would need to be out of that security for the next 30 days.
This prompted a good discussion about the risks associated with not owning the company during that 30-day period and did the resulting tax loss offset a potential rebound in the stock.
The students realized that the market was probably overreacting. As such, given recent volatility, they knew the market could easily rebound erasing any benefit associated with realizing the tax loss.
This left them to ponder the wash sale rule a while longer. The 30-day time period presented an obstacle - but not an impossible one.
They quickly realized that the way the wash sale rule is written, an investor with a losing position can actually "double down" on their losing position. After establishing a second position in the same security, they could then wait out the 30 days.
On the thirty first day they can reassess the situation. Assuming nothing material had changed they could then enter a sell order and specifically request that the shares that are sold are the original ones with the losing position. This is referred to as "selected tax lot" accounting.
By implementing this strategy, the TLU students running Bulldog Investment Company are able to fully hedge their losing position meaning they never had to be out of it.
Furthermore, they are able to "harvest" the tax loss associated with the first position.
Harvesting the tax loss allows them to offset gains incurred throughout the remainder of the year. If an investor does not use up the loss this year, the value associated with the loss carries forward indefinitely until you completely use it to offset future taxable gains. As such, it lowers future tax obligations.
The only downside to this strategy is that it requires you to allocate more capital to this one position which could continue to decline.
As I concluded the lesson with the students in Bulldog Investment Company, I told them that I never thought I would become a "tax nerd." However, every investor needs to realize that what matters most is not what you make, but rather what you keep net of taxes.
Once you realize this, being a tax nerd becomes pretty important to maximizing your portfolio.
Dave Sather is a Victoria Certified Financial Planner and owner of Sather Financial Group. His column, Money Matters, publishes every other week.