Independent Thinking^®

Gaining Ground in Volatile Markets

Patience and perspective are keys to riding out volatile markets. This isn’t usually the best time to make substantive changes to long-term plans, but it can be a great time to adjust tactics – to adjust investment portfolios and wealth transfer strategies in ways that can add up to significant tax savings.
 
Tax loss harvesting should be a staple play, but is often overlooked by investors. By realizing short-term or long-term capital losses now and reinvesting in similar assets, opportunistic tax loss harvesting allows investors to remain fully invested in the market while offsetting gains taken earlier this year, or carrying forward the capital loss to future years when gains may be present. The tax savings can be considerable.
 
For example, shares in Exxon stock that were bought for $50,000 but subsequently slid 20% along with other integrated oil companies, could be sold to harvest the $10,000 capital loss and offset $10,000 worth of capital gains achieved in the same tax year. By purchasing shares in Chevron, say, the investor also maintains similar market exposure.
 
Investors must not reinvest the proceeds in what the IRS deems substantially identical securities within 31 days. Otherwise, the transactions will be considered a “wash sale” and the loss would be disallowed. Selling a specific company stock, for example, and buying another in the same sector might be a good tax loss harvesting move in this market; selling one S&P 500 index fund to buy another might be deemed a wash sale.
 
It’s worth considering tax loss harvesting in the event of an inheritance; securities received typically receive a step-up in income tax basis at death. If that happened in the last few years, it is possible that the securities have unrealized capital losses.
 
Charitable giving in volatile markets is more complex, as it raises a number of important planning considerations. Making gifts of appreciated securities throughout the year allows investors to diversify and rebalance in a tax-efficient and timely manner. Given the recent stock market declines, however, this might be a good time to defer giving or to satisfy philanthropic goals with disbursements from donor advised funds or foundations that can be replenished in future years with appreciated securities.
 
If an individual has held for some time a concentrated low cost stock position in, for example, Johnson & Johnson stock and regularly used the shares to fund a balance in his or her own donor advised fund, it may make sense to utilize the proceeds already in the donor advised fund to meet this year’s gift to a public charity, instead of using the stock at a depressed price. If the stock recovers in 2016, that may be a more opportune time to give shares to replenish the donor advised fund.
 
Periods of market decline can provide a real opportunity to execute wealth transfer strategies using depressed assets, including securities, real estate and private businesses. Continued low interest rates also enhance the outcome of successful estate freeze transactions, such as grantor retained annuity trusts, or GRATs, sales to intentionally defective grantor trusts, charitable lead annuity trusts, and intra-family loans.
 
GRATs can also afford significant transfer tax savings. Investors holding concentrated positions in low-cost securities can consider establishing a GRAT and funding it with stock. If the stock outperforms the IRS hurdle rate (currently 2% for trusts established in October 2015) over the term of the trust, the excess growth can flow to the beneficiary of the trust free of transfer taxes.¹ Here’s how that works: An individual who holds a concentrated low-cost stock position in, say, Apple stock and makes a gift of $2 million of that stock to a zeroed-out GRAT² with a term of three years will, if the stock recovers and earns the equivalent of a 15% rate of return annually over the next three years, receive back $2,080,516 worth of Apple stock in-kind with $633,553 worth of Apple stock passing to his or her children, free of all estate and gift taxes.³
 
For investors who established a GRAT with a stock at a much higher valuation, say Apple two years ago, the trust may now be in danger of failing to meet its objective. In this case, the grantor can use other assets to substitute into the GRAT, taking back the Apple shares to a fund a new GRAT at a much lower initial price. This new GRAT will have a much better opportunity to outperform the hurdle rate. The assets used to substitute into the original GRAT will continue to be invested and likely will revert back to the grantor in the form of the fixed annuity payments. So, no harm, no foul.
 
Investors considering the transfer of real estate or private equity investments as part of wealth transfer and succession planning strategy also have options in these market conditions. Uncertainty may impact independent valuation appraisals of those assets and make them more attractive for gifting purposes. Since these valuation appraisals are performed looking at the underlying assets of these funds, along with a projection of the current market environment, they may now be lower for gift tax purposes, using less of their gift tax exemption.
 
Those who have already established grantor trusts that have private equity, real estate and other private investment commitments requiring periodic capital calls, or follow-on investments, may wish to consider making loans at current low interest rates so that the trusts do not need to sell other securities haphazardly to fund capital calls.
 
Last, but certainly not least, retirement planning also deserves another look in these markets. Investors considering a conversion of a traditional IRA to a Roth IRA may benefit from declines in investment values, as the associated income tax liability, or the cost to convert, could be lower. Those who recently made this conversion may not have missed the boat: The IRS allows for a recharacterization of that transaction for those who incurred a tax liability on a much higher IRA value.⁴
 
Market volatility can be uncomfortable, and it’s important to retain a long-term focus. There are as many variables and considerations as there are people impacted, and interested investors should work closely with their wealth advisors. It may be that tactical changes, even if they seem small now, can significantly enhance a family’s long-term wealth and legacy.
 
Chris Zander is a Partner at Evercore Wealth Management and the Chief Wealth Advisory Officer. He can be contacted at [email protected].

¹ Only if the grantor survives the term of the GRAT.
² A “zeroed-out” GRAT is structured with a stream of annuity payments that have a present value equivalent approximately to the value of the initial gift. This results in little to no taxable gift upon funding.
³ Assumes that annuity payments are made using shares of Apple in-kind and there is no income tax event.
⁴ This must be completed by the last date, including extensions, for filing or refiling prior-year tax return, typically on October 15.