Help Need - 2010 AM Mock Exam - Question 1E

CFA Level III Portfolio Management
#1

Hi guys,

For question 1E of the 2010 AM Mock Exam, I understand that it is advantage to sell the loss position to offset the gain from equities position. For the realized loss, it is (500K - 550 K)*25% = 12.5K, which could be used to offset any tax liability from gain. I have the following inquiries:

  1. Why do we need to sell the equities in tax-deferred account, instead of taxable account to offset the gain, on the face that they are subject to the same tax rate.

  2. Without the cost of equities in tax deferred account, how could we conclude the amount to be sales, so that the loss could be used to offset the gain? In case 500K equities sale from tax-deferred account is all subject to captial gain tax without consideration of cost basis, the capital gain tax would be: 500K*0.25 = 125K >12.5K for the realized loss.

  3. For the later purchase of bond and equities, why the equities in taxable account will be favorable than purchase in tax deferred account?

Thanks a lot!

#2

bonds pay a periodic interest payment, which is taxed at 25%, so you want as much of that as possible in the TDA so you are letting the interest grow tax free.

Equities will have a 15% in capital gains, but as long as you don’t realize it you don’t have to pay it, so it serves to have all your equities in taxable acct.

If possible you would want all in TDA, but since there’s a cap (which is the 75,000) then you want all your bonds in it. Also the question says to maintain 50/50 allocation.

#3

It’s a very poor question I had the same issues.

If you’re selling the bonds to generate the tax loss then you need to sell equities to get your tax bill lower by having some offsetting gains. If the tax harvesting law is going away then you should do this now to take advantage of the loss, carrying forward a loss does nothing if the rule is going away. Makes no sense

#4

I guess they only say “offset income” and I was thinking offsetting capital gains

#5

Hi Ryohko, I don’t see the maximum cap on deferred account from the question. Could you please advise? Thanks

#6

I agree that we need to sell $500k bonds in Taxable account and realize -$50k taxable losses.

But why we need to sell $500k equity in tax-deferred account which has no taxable gains? It’s better to sell $125k of equity in taxable account and realize +50k taxable gains. So, in total, we pay no taxes (-$50k taxable losses + 50k taxable gains = 0) and benefit maximum the taxable losses.

My solution is:

Sell: In taxable account: $500k bond & $125k equity Buy: In tax deferred account: $500k bonds & $125k equity

The portfolio after these transactions:

TDA: Bonds (750k) & Equity (750k) Taxable Account: Bonds ($0) & Equity ($0)

Why my solution is not the most efficient?

Thanks in advance.

PS: From the allocation of CFAI, we can improve it to have a better allocation as follows:

Sell: TDA: Bonds (0$) & Equity ($500k) (realize -$50k taxable losses) Taxable Account: Bonds ($500k) & Equity ($125k) (realize -$50k taxable gains)

Buy: TDA: Bonds ($500k) & Equity ($0) Taxable Account: Bonds ($0) & Equity ($625k)

Final allocation: (same as CFAI’s final allocation) TDA: Bonds ($750) & Equity ($0) Taxable Account: Bonds ($0) & Equity ($750k)