Turning an Oil Loss Into a Tax Win
The fourth quarter is upon us, and energy stocks remain in the doldrums. The broader market hasn’t exactly been setting the world on fire, but most of the sectors besides energy are in positive territory. Thus, you may be one of the many investors like me with taxable gains in some of the non-energy portions of your portfolio, in which case you may want to consider doing some year-end tax selling this quarter.
I generally recommend patience with investments. In the short term markets can be volatile and unpredictable, so my philosophy is to invest in companies that should benefit from long-term trends. For example, I believe that the average price of oil over the next three years will be above the current price of oil by at least 20%. This is based on a number of reasons, many of which I have discussed in previous columns. And since I believe that, I believe it is a good idea to accumulate quality oil companies at the current sub-$50/bbl price of oil.
This is exactly what I started to do after oil fell below $60. Of course we all know that the price didn’t stabilize at $60/bbl. In fact, it briefly breached $40/bbl. Under normal circumstances, I would just sit tight, even though most of the oil stocks I have purchased this year now have double-digit paper losses. After all, I have been through this cycle several times in the past. If oil falls below a price that I believe is sustainable, I will accumulate shares in good companies. I will sit through double-digit losses if necessary and patiently await the inevitable comeback.
This year, I tweaked my usual strategy. It so happens that this year one of my non-energy investments had a relatively large taxable gain. In order to minimize the taxes I have to pay on that gain, I decided to lock in some of losses I have taken in the energy sector.
But I haven’t lost faith in the companies I decided to sell. In fact, I would love to have sold them, locked in the loss, and bought them right back because I believe they are undervalued. But there’s that pesky tax code “wash sale” rule that prohibits a taxpayer from claiming a loss on the sale of a security and then buying a “substantially identical” security within 30 days of the sale.
What does “substantially identical” mean? It obviously covers selling and buying back common shares in the same company within 30 days. Beyond that there is a lot of room for interpretation in the rule. For instance, an S&P 500 index fund run by one company may be deemed by the IRS to be “substantially identical” to an S&P 500 index fund run by another company.
So, I can’t sell shares of ExxonMobil (NYSE: XOM), claim a loss on the sale, and then buy shares of ExxonMobil back within 30 days. But I could replace my ExxonMobil with shares of Chevron (NYSE: CVX).
Since I believe these companies in my portfolio are undervalued, and I need to offset some gains elsewhere in my portfolio, that is the strategy I employed to lock in losses for tax purposes, while maintaining the same exposure to what I believe is presently an undervalued sector.
One of the stocks in my portfolio was Devon Energy (NYSE: DVN). Devon is the 4th largest non-integrated U.S. oil and gas company by enterprise value, behind ConocoPhillips (NYSE: COP), EOG Resources (NYSE: EOG), and Anadarko Petroleum (NYSE: APC). It has made a transition from its roots as a natural gas company to become a major oil producer. Devon’s U.S. production has grown very rapidly, mostly in the Eagle Ford and Delaware Basin (part of the Permian Basin). However, because of the decline in oil and gas prices, I was sitting on a paper loss of 19% on my Devon position.
I actually like EOG more than Devon, but so do a lot of other investors. As a result, EOG trades at a premium to peer companies. I had been looking for an opportunity to add EOG to my portfolio, but wanted to do it at the right price. I did that by locking in my 19% loss in Devon, and then immediately rolling that money into EOG.
This trade gives me a dollar for dollar offset against the gains in the other portions of my portfolio, providing substantial savings in federal and state income taxes. The savings makes it sort of like getting EOG at a discount. This sort of trade makes sense as long as you have gains to offset, and you believe the stock you are buying won’t vastly underperform the one you are selling.
Of course year-end tax selling is a strategy employed by many investors. But there’s a way to employ it without taking a permanent loss near a sector bottom and without falling afoul of the wash sale rule, as my example shows.
Make no mistake: I would rather be looking at gains across my portfolio, instead of locking in losses in order to offset gains. But investors have to use every tool at their disposal to maximize returns. In this case that means taking a loss in order to minimize the check I have to write to Uncle Sam.