How tax planning twist could affect stock rally

As published in the Minneapolis Star Tribune 1/7/2017.

Tax planning strategies can have real impact on short-term stock prices. Investors often sell poor-performing securities in December to offset realized gains and reduce their overall tax bill. This is called “tax-loss harvesting.” The best-performing investments in a portfolio tend to be held through year-end because selling those would have the opposite effect of increasing taxable gains.

The twist this year is that lower taxes expected under the new administration further motivated investors to delay taking profits. It’s widely expected that sometime in 2017, Republicans will repeal the 3.8 percent Medicare tax currently applied to investment gains for high-income families.

This expectation may have contributed to less selling in December, which helped equities hold on to gains earned since the Nov. 8 election. It seems logical that profit-taking will be more prevalent in January, which could lead to a pause in the current rally.

Some investors will take profits this month without knowing the specifics of any tax reform. For individuals intent on realizing gains, it may be enough the calendar has flipped to a new year that brings the likelihood of generally lower taxes.

Others will wait until Donald Trump tweets his detailed proposal to lower taxes on investment gains. The timing, however, remains unknown for now. While tax reform is generally expected to be among Trump’s top priorities, there’s no guarantee we learn the particulars in the weeks immediately after his Jan. 20 inauguration. Even if details do not surface until later, tax cuts typically become retroactive to the start of the year.

One other thing to keep in mind is that tax-loss harvesting tends to exacerbate the gap between the best and worst performers. The weakest-performing stocks tend to get weaker in December since they are targeted specifically for their losses. That trend often reverses a month later once the 30-day Wash Sale provision expires. Consequently, underperforming stocks from the prior year can be among the more attractively valued investments going forward. It may pay to dig through the rubble of last year’s losers in search of opportunities.

The effects of tax strategies do not change the long-term macroeconomic outlook. As we begin 2017, the economic data, consumer sentiment and market momentum all remain positive. When the current equity rally does pause, savvy investors should be prepared to capitalize on the opportunity.

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