Rational Investing: Keep possible tax changes in mind at year's end

Clark Davis is a 30-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money-management company.

"Be careful what you wish for," the saying goes. Some may prefer to allude to unintended consequences. They are pretty much the same. And now they may be brought to the fore by the results of the election.

What, for example, would be the consequences if those of us who would like to see the economy stimulated by tax cuts, got our wish? Trial balloons have gone up (one of my favorite political metaphors) on increasing the amount of capital losses one can deduct. The figures bandied about have been in the range of $7,000 to $10,000.

Now few of us would turn down the opportunity to let Uncle Sam partially subsidize our losses, especially in the investment climate of the past couple of years, but consider what could happen. Let's set the stage by recognizing that investors do tax related selling and buying as year end approaches, a time honored and perfectly acceptable way to attempt to minimize one's tax liabilities. Also, the last quarter of the year finds many mutual funds and institutional money managers doing year-end window dressing kicking out the under-performing issues they would prefer shareholders not see in their annual reports and replacing them with issues seen as more favorable.

Additionally, each December most major brokerage firms provide a list of swap candidates designed to enable their clients to take advantage of tax losses while replacing the sold issues with similar companies in the same industry.

In light of those fairly normal year-end activities, what would happen if we did get what we wish for? Suppose, for sake of discussion, the deductible amount is increased to $7,000. How many investors have that amount or more in unrealized losses in their portfolios? My guess is a lot.

So what would keep them from selling those holdings and turning unrealized losses into realized losses equal to the maximum amount they can deduct?

If that were to happen the volatility could be incredibly high in those issues that declined sharply in value during the bear market. Think tech stocks, telecoms, Internet companies, etc. Look at the high prices some investors paid for such issues in the bubble era that began its meltdown in the first quarter of 2001; Intel ($70 plus), Oracle ($40 plus), Cisco ($70 plus), Motorola ($50 plus), to name only a few from the many former high fliers.

If ego allows (and it often stands in the way of rational investing), many investors are going to toss in the towel and sell to minimize their taxes. That could put more pressure on these fallen angels.

Ah, but all might not be lost. Invariably, tax selling gets carried away in some good stocks, creating an opportunity for the serious investor to establish positions at attractive prices.

So what's an investor to do? If you are going to harvest your losses, start now. One useful technique if you want to maintain ownership in the stock, but establish your loss before year-end while avoiding the wash sale rule, is to double the position and 31 days or more later sell out the original (loss) position. If you are going to use this method, do it soon, as there is very little time left for completing the trades this year.

Do your homework now. Put together your shopping list of companies you want to own positions in that have been beaten down and may come under additional selling pressure if we do see an increase in the capital loss provision.

Is it going to happen? No guarantees, but if it does and you are prepared, you will not be looking back sometime next year and saying that you should have bought Amalgamated Widgets in December of 2002. You can't be proactive after the fact.

A second tax change to watch for: the elimination of double taxation of dividends. This one makes a lot of sense, so don't count on Washington to do it. But if they do, it would be preferable for the benefit to go to the shareholders in the form of elimination of taxes on dividends received. (Expect the tiresome argument that it would benefit the rich, although the liberals are certain to like that more than favoring those evil corporations by allowing them to deduct dividends they pay.)

More than likely the tax would be one of those compromises that involves a phase-in period. But, hopefully, will be permanent, unlike the last changes, engineered by our bipartisan (oh, really?) leaders, and set to expire after 2010.

If this happens it would not only make dividend paying stocks more attractive, but also add to the honesty in the preparation of earnings numbers. It's hard to pay out real dollars from fake earnings.