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• W2301946236 abstract "After-tax performance measurement requires a rigorous definition of after-tax portfolio value. An understanding of after-tax value is also a prerequisite for effective management of taxable portfolios. We propose that the tax option, which is the right to execute tax-beneficial transactions – colloquially referred to as ‘tax-loss selling’– should be included in the value of the portfolio.Currently there are several definitions of after-tax portfolio value in use, including ‘hold’ value and ‘intrinsic’ value. Hold value is the present value of the after-tax cash flows assuming a buy-and-hold strategy. The shortcoming of hold value is that it fails to consider tax-beneficial transactions. Intrinsic value partially corrects for this by recognizing current tax-beneficial transactions. However, intrinsic value does not consider potential future tax-beneficial transactions, i.e. the time value of the tax option. Our proposed definition of after-tax portfolio value is the sum of the hold value and the value of the tax option, including time value. Incorporating the time value of an option is in line with contemporary finance theory. The tax option can be valued with existing industry standard methodology, incorporating investor-specific parameters such as tax rates and mortality rates.Exercise of the tax option is a trade-off: cashflow savings in exchange for forfeited option value. Reinvestment of the proceeds automatically gives rise to a new tax option, whose value should be incorporated into the sale decision. Thus sale and reinvestment also entails swapping an in-the-money tax option for an at-the-money option. Reinvestment in a ‘like’ security ensures that the asset allocation and the risk characteristics of the portfolio remain the same. While the concept of the tax option is applicable to any asset class, municipal bonds, which are normally held in taxable accounts, are especially suitable to illustrate the basic concepts. Due to tax-related factors the hold value of a municipal bond can substantially differ from its market price. This contributes to the complexity of the valuation of the tax option, and it can guide issuers in designing products to appeal to tax-aware investors. According to our analysis, intermediate 5% bonds callable in 10 years are ideal tax-beneficial structures. Remarkably, this coincides with the current market practice of issuing 5% non-call 10 bonds. Unlike a conventional embedded bond option, such as a call or a put, the value of the tax option is not reflected in the market value of the portfolio. Nevertheless, this value should be recognized. Even if option-enhanced value is not practical for external reporting, it provides an added dimension for the portfolio manager by quantifying the value of potential tax-beneficial trading opportunities." @default.
• W2301946236 created "2016-06-24" @default.
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• W2301946236 date "2016-03-14" @default.
• W2301946236 modified "2023-09-25" @default.
• W2301946236 title "After-Tax Portfolio Value: The Missing Tax Option" @default.
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