Update: this article has been updated to accomodate the "wash sale tax
rules". Previously it did not incorporate this rule.
To follow up on previous articles explaining the
Magic Formula tax strategy as well as how
to handle holding periods, this article will present an addition to the
strategy's selling rules that can may save you some money in taxes.
To quickly review, the Magic Formula strategy says to select a stock from the
official screen and hold it
for one year. If it is a winner, you sell after the one year mark to pay capital
gains tax (15%) instead of income tax (up to 35%). If it is a loser, you sell
before the one year mark to reduce your income tax burden.
However, there is often the case where you have a losing position after a
year, but the stock is still on the MFI screen. In this case, especially if it
is a strong company with
durable competitive advantages (like MagicDiligence Top Buys), you may want
to continue to hold the position for another year.
If this is the position an investor finds him or herself in, you may consider
selling anyway and then re-buying after a 30-day "wash sale" period. This of
course assumes that you are using a no-cost broker, which is what you should
always be doing (MagicDiligence recommends Zecco, link below). Let's go through
a couple examples to illustrate why this is the case.
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First, let's take an example where a MFI position lost money for the first
year, and then posted a large gain during the second year, after which we decide
to sell it. For this and the next example, we will assume the initial position
was $10,000 and the investor falls into the 28% income tax bracket with a 15%
capital gains rate. First, let's look at the result if the investor simply held
the position for 2 years, without doing anything:
| Position Held for 2 Years, No Sale |
| Initial Investment: |
$10,000 |
| Value After 2nd Year: |
$12,000 |
| Capital Gains Tax @ 15%: |
($2,000 * 15%) = $300 |
So, by holding the position, the investor would have owed Uncle Sam $300 in
capital gains taxes on his $2,000 investment profit.
However, as mentioned previously, this investment actually lost money
for the first year. What do things look like if the investor sold at the 1 year
mark and then then bought the stock again, after a 30-day wash sale period?
Let's see:
| Position Sold after 1 Year, Repurchased, Sold after 2nd
Year |
| Initial Investment: |
$10,000 |
| Value After 1st Year: |
$9,000 |
| Income Tax Savings @ 28%: |
(-$1,000 * 28%) = -$280 |
| Value After 2nd Year: |
$12,000 |
| Capital Gains Tax @ 15%: |
($3,000 * 15%) = $450 |
| Net Taxes Paid: |
($450 - $280) = $170 |
By selling the losing position after the 1st year, repurchasing, and then
selling slightly after the 2nd year was up, the investor would have paid a net
$170 in taxes to Uncle Sam, compared to $300 by simply holding. That's a
significant 43% savings in tax dollars!
To summarize, Magic Formula investors should consider selling losers right
before the 1 year anniversary. If it's a stock that is still on the MFI screen
and has Top Buy
characteristics, you can then turn around and repurchase it after a 30-day
period.
