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As Tax Season Approaches, Start Harvesting Gains and Losses


It is time to look for gains or losses in your portfolio to harvest in order to minimize your tax bill come April of 2013.

Effectively, if you sell a position to harvest a loss and purchase the identical ETF/stock within 30 days of the sale, you will have established a wash-sale. The IRS would say that you did not effectively sell it and you will not be allowed to take the loss in that tax year.

If you still want to effectively own the stock/ETF but want to harvest the loss, you could consider selling the stock/ETF and purchasing a deep in-the-money call option on the same stock/ETF. This position will behave in a very similar manner as the stock. If it is a deep in-the-money call, it should have a high delta – meaning that the value of the call will move close to $1 for every $1 the stock moves.

You could hold this call option for 31 days after selling the stock to harvest the loss, and then close the deep ITM call and repurchase the stock again. This technique helps you avoid the wash-sale rule while capturing just about all of the move in the stock price as if you actually owned the stock.

But because the call option is technically a different investment vehicle than the stock, it does not trigger the wash-sale rule. Your risk in owning the call is slightly different than the risk of owning the stock, and so the IRS recognizes that risk as a different position and does not invoke the wash sale.

I would recommend looking at March '13 or April '13 deep ITM calls for your substitute option. The December or January options would have too much time decay over the next 30 or so days to be a good stock replacement. If you use the March or April options and sell by early January, you should still retain most of the very little time value you pay to enter that option.

This is a nice technique for harvesting losses to offset gains without having to exit your exposure to the stock. You have created synthetic exposure to the stock that has a slightly different risk profile, but moves almost dollar for dollar like the underlying stock/ETF.

Tips to consider when harvesting gains/losses at year end:

Tip No. 1: Don't forget that any positions you own in your portfolio on index future options (like S&P 500 (INDEXSP:.INX) or Nasdaq-100 (INDEXNASDAQ:NDX)) must be marked at year end. That means you must take the gain or loss on the position as of Dec 31, as if you closed the position even though you haven't. Remember to consider that when determining the total realized/unrealized gains or losses you expect for the year.

Tip No. 2: Before you harvest a loss and hold the option for the next 30 days, make sure to look at the ex-dividend date for the stock/ETF. If the stock is going to go ex-dividend in the next 30 days, consider waiting until after that date to execute this strategy. Many stocks and ETFs have an ex-dividend date that will occur in late December. The option holder will not get paid the dividend as only the stockholder gets that. So execute the trade to move to the option after it goes ex-dividend. Then wait the 30 days in to January and move back in to the stock.
No positions in stocks mentioned.
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