David R. Evanson

Investment News, Summer, 2003

Seth Morris, a software salesman who lives in Washington, doesnzzt like to talk about the losses in his portfolio last year. After a year of denial, he bit the bullet and sold off the losers.

“It was enough that it really hurt,” he says. “I remember when I was buying Exodus, JDS Uniphase and Cisco, I was telling friends that getting into these stocks was a no-brainer. It turns out, I was the one without the brain.”

But the stars are aligning for Mr. Morris – and many other clients of advisers – in ways that can ease the pain a little bit.

Specifically, the ability to carry his losses forward, changes in tax laws and a broad advance across the markets so far in 2003 mean that Mr. Morris and other individual investors can cash out of some of their positions and take capital gains without paying the tithe to the taxman.

Given that so many investors are in the same boat as Mr. Morris, what should advisers be telling their clients right now?

Joe Garner, director of research for West Palm Beach, Fla.-based Emerald Advisors Inc., which manages $1 billion, says investment advisers “should be looking hard at clientszz portfolios and counseling them to take gains in stocks where the growth strategy is no longer intact.”

Mr. Garner says advisers need to help clients learn from the lessons of the past three years and take some money off the table.

“Too many investors watched spectacular gains turn into spectacular losses,” he says. “Now that the markets are showing some profits, itzzs important that investment advisers make sure that their clients take profits now and donzzt repeat recent history in stocks where the price has been realized.”

David Kovacs, a senior portfolio manager at Turner Investment Partners Inc. in Berwyn, Pa., says, “I am not recommending investors selling right now per se. However, I am recommending investors maintain their asset allocation.”

“With the advances in the market, many portfolios are overweighted in equities and investors should sell what they are overweighted in, and buy what they are underweighted in,” Mr. Kovacs adds.

While experts say tax considerations should never be the basis for buy or sell decisions, many believe that the favorable tax treatment investors can enjoy right now may help advisers counsel their clients to do the right thing.

Larry Weiner, a principal with the accounting firm of Weiner Daly & Co. in Elmsford, N.Y., says investors and advisers should look closely at Internal Revenue Service regulations on capital gains and losses.

“In any taxable year, capital gains from securities, and the federal tax owed on them, can be reduced by the amount of capital losses realized during the period,” Mr. Weiner says.

But the past three years have delivered more losses than gains, and Mr. Weiner says many investors, like Seth Morris, have found that their losses far exceed their gains.

“The first $3,000 of losses in excess of gains can be thrown against adjusted gross income, but after that it must get brought forward, and can be used at the election of the taxpayer to shelter future capital gains,” Mr. Weiner says.

For investors, the ability to avoid federal taxes on capital gains they are now enjoying has the benefit of significantly enhancing returns.

Based on the new law, the tax rate on long-term gains taken after May 5 is 15%. “That means a $10,000 long-term gain taken in 2003 that is sheltered by losses from prior years is equivalent to a $11,800 gain on a fully taxable basis,” Mr. Weiner explains.

Said differently, investors benchmarking their performance against the Standard & Poorzzs 500 index, which was up 14.8% year-to-date as of Wednesday, would need to see the index advance another 17.96%, to 1192, to get the same return on a taxable basis as they can realize right now by taking profits.

For investors who took long-term capital gains before the new tax law went into effect and must pay a capital gains tax of 19%, the numbers are even more compelling. A profit of $10,000 sheltered by losses is the tax equivalent gain of $12,345.

For advisers, the trick is not to focus directly on taxes, but on some of the fundamentals of asset allocation and stock valuation.

“When advisors do this,” says Mr. Kovacs, “they will very likely find some sell triggers. If their clients can take profits without paying any taxes, then so much the better.”