Tax-Loss Harvesting Municipal Bonds: A Primer

The goal of tax-loss harvesting is to recognize for tax purposes the losses on investments whose value declined. Currently short-term losses can be written off at 40%, long-term losses at 20%. Tax-loss harvesting is an investor-specific option, which requires professional management. Although munis are always held in taxable accounts they have received little attention, and this article focuses on the unique aspects of the tax-exempt municipal bonds. Due to the so-called de minimis effect the prices of munis selling below par are further depressed. Selling at a discount can save tax and yet lose value at the same time. For this reason, bonds purchased near par are not suitable candidates for tax-loss harvesting; bonds selling at a premium are recommended instead. Proper analysis requires the so-called tax-neutral OAS method, which accounts for the behavior of discount munis. A complicating consideration is that the benchmark municipal yield curve is specified by the yields to call of 5% bonds, which should be converted into conventional interest rates. Periodic after-tax return should be measured and reported to the interested parties. This calculation requires the specification of after-tax portfolio value. Instead of the CFAI’s GIPS method, the so-called tax-smart approach is recommended.