Financial advisors always look for ways to minimize tax liabilities for clients at year’s end, and many utilize tax swaps (and especially bond swaps) in pursuit of that annual goal. However, bond swaps take on an added urgency this year. With interest rates expected to rise, advisors can use bond swaps to not only mitigate tax liabilities, but also improve the quality of their clients’ fixed-income holdings going into 2015.

What Is A Bond Swap?
A bond swap entails selling a currently held bond or bond fund where an investor has a loss and repurchasing other bonds, bond funds or unit investment trusts (UITs) with the proceeds. By recognizing the loss in this way, an investor can offset up to 100 percent of any capital gain on another investment as well as up to $3,000 per year in regular income. This process allows advisors and investors to essentially exchange bonds and bond funds for assets with better credit quality and longer or shorter maturities—while neutralizing portfolio losses and pushing taxable gains into the future.

Tax swaps tend to work best with tax-exempt municipal bonds, corporate bonds, bond funds and collateralized mortgage obligations, though almost any bond or equity security can be successfully swapped as long as a suitable replacement can be identified. However, if the replacement is deemed by the Internal Revenue Service (IRS) to be “substantially identical” to the previous security, the loss may be disallowed under the IRS “wash sale rule.”

Avoiding Wash Sales
A wash sale occurs when a security is sold at a loss and the investor buys a “substantially identical” investment within 30 calendar days before or after the sale. In the event of a wash sale, the capital loss is disallowed and postponed until the new security is sold. That sale would likely take place in a future tax year, when the deduction might be much lower. If an investor sells a security with a loss in a taxable account and purchases a “substantially identical” investment in his IRA within 30 days, this is also considered a wash sale. To ensure they do not violate the wash sale rule, investors and their advisors should consult certified public accountants (CPAs) and other tax experts before attempting any tax swaps.

Cogent Swap Examples
Investors seeking to implement tax swaps can generally avoid running afoul of the wash sale rule by purchasing bonds with substantial differences from those they sell. For example, selling a public infrastructure or utility bond and using the proceeds to buy a public school bond from the same state or municipality should not be considered a wash sale.

Let’s say an investor has a $225,000 position in a $200 million, AA-rated California industry public finance bond that has a 4.125 percent coupon and is set to mature on August 1, 2019. This investor could implement a tax swap to generate $220,000, and use the proceeds to purchase a $217,200 position in another security—a $200 million, AA-rated public education bond issued by Oakland, Calif., with a 5 percent coupon, a maturity date of August 1, 2022, and a call date of August 1, 2016. The $5,000 loss incurred by the investor can be used to offset capital gains on other investments, or offset up to $3,000 in regular income.

This tax swap also allows the investor to increase his income by $1,750 per year, while maintaining the AA rating on his investment. Furthermore, the new bond extends the investor’s maturity by three years, though in this case it is subject to an early call, which can lower interest-rate risk in his portfolio.

In addition, selling a municipal bond and purchasing another municipal bond from a different state or municipality would not be a wash sale. This is good news for holders of downgraded public debt from New Jersey and Illinois, who could use tax swaps to buy similar but higher-rated securities from Texas. The Lone Star State’s municipal bonds currently pay high yields because Texas has no state income tax and is experiencing a boom in energy production and investment.

Don’t Wait Too Long
Bond swaps are a viable option for advisors to help investors simultaneously reduce tax liabilities and interest-rate risk at any time, but swaps implemented before December usually generate better outcomes for investors. The longer an investor waits, the more likely his swap will be adversely affected by the swell of mutual fund and individual investor sell-offs in December. Advisors should take the lead and discuss swap opportunities with their clients now rather than later, thereby avoiding the market’s year-end trading capacity limitations.

Scott Colyer is chief executive officer and chief investment officer of Advisors Asset Management, Inc. (, a trusted investment solutions provider for financial advisors and broker-dealers.