Fagan Associates Archive for December, 2007

One of the least time consuming and most profitable tasks one can assume during December as it pertains to their investment portfolio is to attempt to offset realized capital gains with capital losses in your portfolio. Given the level of volatility the stock market has dealt investors thus far during 2007, no doubt many of us have securities that have declined in market value relative to their purchase price. Assuming that the shares of the depreciated security are held in a non-qualified taxable account (not an IRA or pension plan), one might sell these shares and claim the loss on Schedule D of Federal Filing Form 1040.

Please note the following important IRS regulation that pertains to Capital Gains and Losses. If when comparing your realized (those securities sold or where the company has been purchased for cash by another company) gain with your realized loss, the net result is a loss, only up to $3,000 can be deducted from ordinary income. The balance can be carried forward, indefinitely.

An additional component to consider prior to realizing a capital gain or loss in your portfolio is whether the transaction would trigger a long-term versus short-term capital gain/loss. Long-term transactions are defined as those in which the underlying security has been held for one year or longer and are taxed at either five percent for taxpayers in the ten or fifteen percent bracket or at fifteen percent for taxpayers in any higher bracket. Short-term transactions, those which the security has been held for less than one year are taxed as ordinary income and subject to the same tax rate as your wages or dividend income. For most taxpayers, the rate is twenty-eight percent for the Federal Government. In both instances, for taxpayers in New York State, long-term and short-term capital gains are taxed as ordinary income.

One final consideration prior to executing a stock or bond trade for tax purposes would be to determine if, by executing this trade, a wash sale would result. A wash sale exists when the transaction results in a loss and a “substantially identical security” is purchased within thirty days. If this should occur, the tax loss created by the sale would not be deductible. Please note that should the wash sale result in a gain, the gain is taxable.

As an aside, never forget that it is always prudent to consider the impact of selling a stock upon your portfolio. Simply put, it is seldom wise to make a transaction solely for the purpose of saving money on your tax return!

Year-end tax planning also applies to your mutual fund investments. First and foremost, place a call to the service center of your mutual fund and ask them if they have declared or are planning to declare any year-end capital gain distributions.Keep in mind that capital gains declared by mutual funds are taxable regardless of whether you receive them in cash or reinvest in additional shares. Furthermore, there is no economic benefit to the distribution. It is the same as getting four taxable quarters in return for your non-taxable one dollar bill. Upon calling, should you learn that your mutual fund is intending to declare a capital gain, find out how much it will be on a per share basis and on what date it will be declared. This information will help you determine what steps, if any, need to be taken in order to minimize the impact of this declared gain.

Consider swapping the mutual fund in which you have a taxable loss for a similar fund. Please note that your adjusted tax basis consists of your initial contribution to the fund plus any subsequent out-of-pocket contributions as well as any reinvested dividends or capital gains declared during prior calendar years less any withdrawals. Regardless of what others might say to the contrary, given the fact that there are over eight thousand mutual funds to choose from, there is always an appropriate alternative to your current fund. Do not think that your fund is “the best” or “one of a kind.”

A sale or sales of appreciating and/or depreciated securities represent only one tactic an investor can deploy when tax planning at year end. Furthermore, please note that this decision must be made in conjunction with and in full knowledge of the resulting impact on your other investments, such as mutual funds. Be certain to check with your tax advisor prior to making any year-end portfolio transactions!

After a $7.5 billion cash infusion by the sovereign wealth fund of Abu Dhabi into Citigroup, comments by Federal Reserve Vice-Chairman Donald L. Kohn and a more than 500 point two-day run-up by the Dow Jones Industrial Average, investors must be asking, what next. Our response, let’s tackle this question by looking at the headlines noted above that created the catalyst for this move.

Prior to this past Tuesday investors have expressed their concern about the value of many of our largest money center banks, including Citigroup, Bank of America, JP Morgan Chase, as well as our largest brokerage firms, by a stampede of selling which, in turn, sent the share price of those affected down by more than 20%, this during November alone. Those selling were doing so because of the uncertainty regarding the multi-billion dollar negative impact caused by the weakness in the housing market, an ever rising default rate on mortgages as well as home equity loans, and the perception that the malaise in the housing market is spreading into the entire credit market thereby creating a credit crunch and a resulting liquidity crisis. To the rescue, at least for the time being, rode the country of Abu Dhabi in the form of a $7.5 billion cash infusion into Citigroup, from its sovereign wealth fund, a fund created by the monarchy and funded, in great part by their export of oil reserves to the United States as well as other countries. The fund, whose value is estimated to be close to $900 billion, is meant to benefit the monarchy of Abu Dhabi, its ruling family as well as the citizens of this Middle Eastern country. That said, what does this mean to Citigroup? It means that, certainly after a tremendous amount of due diligence, a tremendous amount of “tire-kicking,” an entity decided that Citigroup was worth an investment of $7.5 billion. Some might suggest that although $7.5 billion is not a lot of money, noting that it is “only” 8.3% of the value of this fund, implying that Abu Dhabi could afford to lose their investment. To the contrary, we suggest that Abu Dhabi is investing for the long-term, that they perceive long-term value in Citigroup shares at their current price and, stand ready to infuse more cash, if necessary. Time will tell who will ultimately prove correct in their analysis of Citigroup, the naysayers who suggest that Citigroup, the world’s largest bank still has substantial downside, or, we, at Fagan Associates, that recommend investors dip their toes in the water with a small investment in these shares, recognizing that the shares may not have bottomed, but like the country of Abu Dhabi, stand ready to purchase a little more should the share price still move a bit downward in hopes of much higher shares prices one to five years hence.

Quite briefly, contained within the text of a speech entitled “Financial Markets and Central Banking” and under a section sub-titled “Moral Hazard,” by Vice-Chairman of the Federal Reserve, Donald L. Kohn, was the following statement. “Losses were evident early in this decade in the case of many high-tech stocks, and they are in store for houses purchased at unsustainable prices for mortgages made on the assumption that house prices would rise indefinitely. To be sure, lowering interest rates to keep the economy on an even keel when adverse financial market developments occur will reduce the penalty incurred by some people who exercised poor judgment. But these people are still bearing the costs of their decisions and we should not hold the economy hostage to teach a small segment of the population a lesson.” Simply put, we are not going to penalize the entire country to penalize a precious few. Bottom line, lower interest rates are on the way, perhaps when the Fed next meets on December 11^th (we believe this is the case), in an effort to stimulate a sluggish economy.

This vote of confidence in our financial system, ironically expressed by a sovereign fund of a foreign investor along with “dovish” comments by Vice-President Kohn suggesting lower interest rates are in store, in our opinion, will ultimately result in higher stock prices. Our recommendation, some “backing and filling” after the 500 point jump in the Dow is in order, but investors would be wise to accumulate stocks and/or stock based mutual funds should such weakness occur.