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What is a Tax Swap?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 22 August 2016
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Tax swaps are strategies that involve the sale and acquisition of two different but similar securities. A tax swap is usually conducted as a means of utilizing existing tax laws to realize a loss that can be applied to the overall tax obligation for a given tax period. As such, the tax swap is a legitimate means of managing taxes so that the individual or entity creates a smaller tax burden for the period.

The process for creating a tax swap is relatively straightforward. First, the investor will identify a security within the current portfolio that has been in decline. This rate of decline must take the current market price for the security below the price originally paid by the investor.

Second, the investor will identify a security current offered for sale. This new security must be similar to the security that will be sold, but cannot be different shares of the same security. The purchase price for the new security must be more than the sale price for the old security.

By selling the declining security and acquiring a similar but higher priced security, and making both transactions in the same tax period, the investor generates a loss that can be utilized when tax time arrives. When conducted according to current laws regarding investments, this creation of a loss for tax purposes is considered to be perfectly legitimate.

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While the process of a tax swap looks appealing on the surface, there is an element of risk involved for the investor. First, the original security could reverse the current trend and begin to rise again, perhaps exceeding the original purchase price. This would mean the investor would not receive the benefit of the increase, since he or she no longer owned the security.

Second, the newly acquired security could in short order experience a downward spiral, creating more of a loss than the investor had hoped to achieve. If the loss is too great, it could mean financial problems for the investor. As a result, the main purpose of the tax swap is defeated and the investor has to engage in damage control.

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