Bond Swaps

This is another classic year-end maneuver. The point of the swap is to lock in a tax loss by selling bonds that have fallen in value and reinvesting the proceeds in bonds that are not substantially identical to the bonds you sell. Done right, you can maintain the income stream from your bonds. Consider this example:

Assume you own $100,000 worth of AA-rated bonds with a 7 percent coupon and a maturity date in 2016. In November, as you begin your year-end planning, the market price of your bonds has slipped to $84,750. If you sell at that price, you'll have a $15,250 loss. At the same time, assume you can buy $100,000 face value of an AAA-rated bonds, with a 7 percent coupon and a 2015 maturity, for $83,612.

If you sell one set of bonds and buy the other, look what happens: Since they have the same par value and coupon rate, your annual income remains the same: $7,000. Your bond rating increases from AA to AAA. You pull $1,138 out of the investment - the difference between what you got for the old bonds and what you paid for the new ones. And you can claim a $15,250 tax loss. If it offsets gains that otherwise would have been taxed at 25 percent, you save $2,288. As with much year-end tax planning, the earlier you begin scouting for promising candidates for swapping, the better. The supply dwindles and competition from other investors heats up as the year draws to an end.

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