Markets are rallying. How to make the most of them.

Since the stock market has bounced back this year, many of the largest losers are now in bonds. (Ilustration: Kierstein Essenpreis for WSJ)
Since the stock market has bounced back this year, many of the largest losers are now in bonds. (Ilustration: Kierstein Essenpreis for WSJ)

Summary

Bonds haven’t gained nearly as much as stocks this year. Put losses to work now to cut your taxes.

Stocks have erased almost all their losses since the beginning of 2022, when the Federal Reserve began its campaign of interest-rate increases. Bonds have also rallied, but not nearly as much.

For investors making year-end tax moves, this presents an unusual situation. Often those who want to take gains on stocks look to “harvest" losses elsewhere in their portfolio to lower their tax bills. But for years this didn’t include selling bond and bond funds, as losses were scarce during the decade-plus era of super-low tax rates.

Now, many bondholdings remain in the red, despite the market’s rally since mid-October. For the three years ended Nov. 30, the cumulative loss in price for both corporate and intermediate core bond funds is about 20%, according to Morningstar Direct. (Bond prices, which exclude income payouts, are a better measure of investors’ gains or losses for tax purposes than total returns.)

The good news is that these losses have a silver lining. As with losses on stocks, investors can use them to reduce taxes on their investment gains if the bonds or bond funds are held in taxable accounts rather than tax-sheltered retirement accounts such as IRAs or 401(k)s.

“For investors, the biggest opportunity to limit taxes and reposition portfolios right now could be tax-loss harvesting in fixed income," says Karen Veraa, head of iShares’ fixed-income strategy in the U.S.

Here’s why. Under the tax code, investors can sell losers and book a capital loss, typically for the difference between a holding’s purchase price and its sale price. These losses can then offset taxable capital gains from selling winners. The gains don’t have to be from a similar asset, so bond losses can shelter gains from selling stocks or real estate.

That’s not all. If an investor has more losses than gains, then up to $3,000 of losses can be deducted from ordinary income such as wages or interest. Even sweeter: Unused losses carry forward for future use.

Savvy investors use these rules to cushion blows from down markets and reduce the cost of resetting portfolios. And since the stock market has bounced back this year, many of the largest losers are now in bonds.

Say that Martha has a high-fee stock fund she wants out of, but selling it will trigger taxes on $25,000 of gains. However, she also has a corporate bond fund with $30,000 of current losses. If she sells both positions before year-end, the bond losses can offset the tax on the stock gains plus $3,000 of income, leaving $2,000 of losses for future use.

What if Martha wants to maintain her bond allocation, as many investors do? She’ll be penalized if she repurchases her fund right away. But she could buy a similar fund to protect against sudden market moves, hold it for 30 days before selling, and then repurchase her original holding.

This isn’t a totally free ride. The cost basis of Martha’s bond-fund investment will likely reset lower at repurchase, and that’s the starting point for measuring future taxable gains.

That could raise Martha’s potential tax on the fund when she sells it—but maybe by then she’ll have other losses to shelter those profits. Or she might hold the fund until her death, when (under current law) there won’t be income tax on the gains. Meanwhile she has achieved a principal goal of tax planning: deferral.

If you’re thinking of harvesting losses on bondholdings, here’s more to know.

Be careful with timing

Losses on investment sales carry forward until they are used, but they can’t reduce taxable gains from a prior year. So a loss taken in December 2023 can offset gains from a sale earlier in 2023 or in the future. A loss taken in January 2024 can’t be applied to gains from 2023.

Practices vary among investors. Brooke Mayne, a fixed-income portfolio manager at Goldman Sachs Asset Management, says some clients harvest systematically throughout the year, while others wait until year-end if they have gains to offset.

Consider loss thresholds

IShares’ Veraa says a good benchmark for taking losses is $3,000, the amount that can shelter ordinary income per tax return each year.

Elliot Dole, an adviser with Buckingham Strategic Wealth, says that before harvesting he often looks for a loss of at least 5% and $5,000. Still, he calls loss harvesting an art, adding, “You have to consider how much your time is worth, and the options for replacements."

Avoid wash sales

Investors who repurchase an identical bond or bond fund within 30 days of selling it face “wash-sale" penalties that delay use of the losses. To maintain portfolio allocations and protect against market shifts, many investors switch into similar but not identical holdings for that 30-day period.

The line between “similar" and “identical" is fuzzy. Robert Willens, a CPA and longtime independent tax analyst, says it can be easier to avoid wash sales with bondholdings than stockholdings because bonds often differ in more ways than stocks.

He gives an example in which two funds both hold Treasurys. If one has short-term debt while the other holds intermediate-term debt, then buying one right after selling the other likely isn’t a wash sale. But if two funds match the same bond index, then selling one and buying the other probably is a wash sale.

Note that the wash-sale rules only apply to investments sold at a loss, not at a gain.

Evaluate losses on individual bonds

Investors can harvest losses on individual bonds as well as bond funds. For example, says Dole, losses are often easy to spot on the different rungs of a bond ladder.

For individual bonds, the capital loss is typically the difference between the bond’s purchase price and its sale price. For a bond bought at $1,000 and sold at $800, the capital loss would be $200.

If the bond was bought at a market discount and has fallen further, then the sale will also produce a capital loss measured in a similar way, says Willens.

If a discounted bond has appreciated instead, then a portion will likely be taxed as ordinary income and the amount above that will be capital gain. Special rules apply for bonds issued with discounts rather than at par value.

Write to Laura Saunders at Laura.Saunders@wsj.com

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