Re-printed from acapam.com with permission.

As you’ve no doubt been following, global markets have been extremely volatile as the world attempts to pull itself out of the Great Recession. Leaders worldwide are pulling every lever possible in an attempt to stabilize their countries’ economies and instill investor confidence.

Recently, the Federal Reserve introduced “Operation Twist” to lower long term interest rates by flattening the yield curve in an effort to make home prices more affordable. At the same time, the U.S. government is struggling to cope with a $1 trillion budget deficit. Across the pond, the European Union is debating what to do with Greece and Italy, how to recapitalize Europe’s major banks, and of course maintain the euro. In addition, the growing voices of protesters in major cities, such as those of Occupy Wall Street, are fueling public anger over the widening disparity of wealth. It is no wonder that markets worldwide are directionless and jittery with every new stimulus measure. Governments are scrambling to find the silver bullet to alleviate market jitters, but there is only one thing that will calm investors’ minds: predictability. Investors hate uncertainty, and there has never been a time in recent history when there has been so much uncertainty over the future of taxes, currencies, budgets, and regulation.

One of the most significant unknowns is taxes. The Bush Tax cuts, enacted in 2001 and 2003, are set to expire in 2012, coinciding with what looks-to-be a heated Presidential race centered on tax reform. Momentum is growing on raising taxes; but whether it will be in the form of a tax on the wealthy, a flat tax, or 9-9-9, is anyone’s guess. Unknown future tax rates contribute to volatility because savers evaluate potential investments based on projected future net (after-tax) cash flows. Investors discount future net cash flows using a reasonable cost of capital to determine an estimated current market value for an investment (whether it is a stock, real estate, company, etc.). Very small changes in the after-tax cash flows lead to large fluctuations in the calculated present values. If investors do not know how much they expect to pay in future taxes, the range of discounted present values becomes wide and therefore, meaningless. Given that 2012 is an election year, it is unlikely that any tax changes will be made between now and then. Investors, meanwhile, are left in the dark. This uncertainty explains, in part, why corporations are sitting on large piles of cash, waiting to see how they will be taxed.

Furthermore, no one knows the future of Greece, Italy, and the euro. The Eurozone is tangled in a really difficult conundrum. According to analysts, there is a 98 percent chance that Greece will default on its debt. A Greek default, which has still not been entirely ruled out, would reverberate among the PIGS (Portugal, Italy, Greece, and Spain). The Eurozone’s largest countries, Germany and France, are discussing a bailout fund to purchase the debt of distressed Eurozone countries and/or issue Eurobonds (like U.S. Treasuries). Unlike the Eurozone, the U.S. can tax its citizens and pay interest on its debt. The Eurozone, comprised of 17 countries that share the euro currency, has one monetary policy system, managed by the European Central Bank (ECB), with 17 different fiscal policies. This means that while the ECB sets interest rates for the entire Eurozone, it has no taxing authority, leaving each country responsible for its own budget. This bifurcated structure also explains why the euro will struggle to be a reserve currency (stay tuned for a future article on this topic).

Increased government regulation is all but certain, but the details of those regulations are still being debated. Whether it is a Wall Street transactions tax or the reintroduction of the Glass-Steagall Act (passed during the Depression; it separated traditional banks from investment banks.) The International Monetary Fund (IMF) recently held its annual meetings in Washington D.C. with attendance from heads of major international banks. The most pressing issues on bankers’ minds were not European solvency, future of the euro, or the global recession, but rather, the future of regulation, specifically, the Frank-Dodd act and Basel III capital accords. The Frank-Dodd act is one of the most far-reaching financial regulatory reform measures taken since the Great Depression. Many of its provisions have yet to be finalized, which is why several industries are in limbo. The Basel capital accords are international standards that require banks to hold minimum capital levels commensurate with their risk. Banks are reluctant to make any significant changes or investments until they see the final versions of these two sweeping regulatory measures.

The world, the markets, and investors all over the globe are waiting; they are waiting for their governments to act with clear direction and consistency, instead of temporary band-aids. The most recent debt ceiling debate in the U.S., and the subsequent downgrade by S&P, was an embarrassing black eye for Americans. It demonstrated that Washington is not focused on solving macro economic problems. U.S. companies will not deploy their huge cash reserves into profitable investments, which lead to hiring, until there is relative calm in Washington and a somewhat predictable tax environment. No amount of quantitative easing or temporary tax holidays will incentivize companies to begin hiring or spending their huge cash reserves. Companies are looking for concrete policies from Washington, stable and predictable taxes, consistent and fair regulations, and some form of stability in the Eurozone. We need a long term solution to the debt problem combined with a fair, yet predictable, tax code.

Ara Oghoorian, CFA, CFP® is the president and founder of ACap Asset Management, Inc., a “Fee-Only” financial advisory and investment management firm located in Los Angeles, CA. Contact Ara at aoghoorian@acapam.com or on the web at www.acapam.com for a complimentary consultation.

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Re-printed from acapam.com with permission.

When life gives you lemons, make lemonade – so the saying goes. Hence, when the market gives you losses, avoid paying taxes. Taxes come in many shiny packages (income, sales, capital gains, property, estate, etc.), and while some are hard to avoid, others can be easily be minimized. Many of us have made tax deductible donations throughout the year that help our favorite charities and lower our taxable income, but only a few harvest losses. Tax loss harvesting is the act of intentionally selling an investment at a loss to offset current and/or future capital gains. If executed properly, it is a powerful technique used to significantly lower one’s taxable income and hence taxes.

Of course everyone prefers to see their stock portfolios rise in value, even if that means having to pay tax on capital gains. But as we have painfully witnessed in recent years, portfolios can also incur losses. While no one likes to see their investments go down in value, savvy investors can capitalize on such losses and do as the old saying goes, “when life gives you lemons, make lemonade.” Current IRS rules limit capital loss deductions to only $3,000; the good news is that losses greater than $3,000 can be carried over and used in future years. For example, assume you purchased an investment for $20,000 and sold it for $10,000, you can only deduct $3,000 each year from your taxable income. The remaining $7,000 would carry over to future years to offset future capital gains. So if the following year you sold another investment for a $15,000 capital gain, you would pay tax on only $8,000 ($15,000 – $7,000). Tax loss harvesting is when you intentionally sell an asset (even if you still like the asset) to recognize and bank (harvest) the loss for future use. Here is how it works.

Assume you bought investments in 2007 worth $100,000, but they are now worth $60,000. You initially purchased the investments for long term growth and have no intention of selling them because the investment still helps meet your long term goals. While you have a 40 percent loss, the loss is unrecognized because you have not sold anything. By harvesting your losses, you would sell your investments now, realize a $40,000 loss which you can save to offset future capital gains, and repurchase your investments. Your investments would still be worth $60,000, but now you have “lemonade” you can drink for years to come. You are still only limited to $3,000 per year in losses as discussed above, but now you have $40,000 in losses you can save and use to off-set any future capital gains for multiple years that only expire upon death. So let’s assume you had no other sales for the next few years and then after 5 years, you sell a rental property for a $50,000 gain, you can use the $40,000 loss to off-set that gain and only pay tax on $10,000. This will substantially decrease your taxes.

As with everything, the IRS has rules and limitation. The IRS wash-sale rule stipulates that if you sell an investment to recognize a loss, you cannot buy another “substantially identical security” within 30 days. So for instance, if you sold State Street S&P 500 SPDRs (ticker: SPY), you cannot replace it with the iShares S&P 500 Index (ticker: IVV) because they both own essentially the same investments. However, you can purchase a temporary investment that is not essentially same, but is highly correlated. Using the same example, you could sell the SPY to recognize a loss and purchase the iShares Russell 1000 Value Index (ticker: IWD) as its replacement. The two assets are not essentially the same, but they are both highly correlated and tend to move in tandem.

No one likes to lose money on their investments, but when the markets are as volatile as they have been these last few years, give yourself the gift that keeps on giving for years to come – harvest your losses. If done properly, you could avoid paying taxes on capital gains for years. Please be aware that tax loss harvesting is only relevant in your taxable accounts, and not in your IRAs, 401ks, or other tax efficient investment vehicles. Each person’s tax situation is different so investors should consult with their financial and tax advisors.

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