Oct 22, 2021

Tax Returns Can’t Be Sole Tool in Evaluating Client Portfolios

Angie Stephenson, CPA, PFS, CFPBy Angie M. Stephenson, CPA, PFS, CFP

Wealth advisers often hear from clients and their tax preparers with questions about their portfolio or proposals to collaborate. Working with tax preparers and incorporating the information they gather is a good idea, but just working off a tax document can be a unrepresentative start.

In many cases, it can be difficult to look at the results of a tax return and fairly assess how well a client’s portfolio has performed over the past year. It can be very deceiving to assume the portfolio reporting in the tax return is truly representative of how much a client has made or lost in their overall portfolios.

So, why would the amounts reported in a tax return not clearly represent how a portfolio performed?

Tax forms and cashHere are some examples of how the tax return details are not a clear representation of how a client’s portfolio has performed or should be allocated, diversified, or used from a pure economic prospective.

Client has a net realized capital loss of $40,000 for the year. The immediate reaction is to assume the client’s portfolio had a negative performance for that same year.

The reporting of realized capital losses is not an indication that the client lost money in their portfolio for the year, even though that’s how it appears at face value. Wealth advisers who manage portfolios in a tax-sensitive manner frequently take advantage of declines in the stock market throughout the year to harvest tax losses.

In 2020, this type of tax harvesting easily could have taken place. When the pandemic hit in March 2020 and stock indexes fell double digits, this presented an opportunity to look for portfolio positions that reflected capital losses due to the large declines in the markets. A tax-efficient adviser would have considered selling those positions to realize the losses for tax purposes. It is important to note that, on the exact same day, the wealth adviser would have purchased a “similar” replacement investment. Note the word “similar” to avoid running afoul of IRS “wash sale” rules. This strategy allows the client to have a reportable capital loss while staying invested in a similar manner to capture positive returns when the markets start to improve. This is exactly what occurred in 2020: taking losses in March and April but staying fully invested allowed clients to be tax sensitive while continuing to participate in the positive market returns for the balance of 2020.

Even though the client reported a rather large capital loss of ($40,000) in 2020, the portfolio performance was positive and kept pace with the markets and indexes in how they were invested. The realized capital loss reported in the tax return was in no way indictive of negative performance in the client portfolio.

The client reports realized capital gains and capital gain distributions of $60,000 for the year. Can you assume that the portfolio had positive performance for the year?

The reporting of realized capital gains is not always representative of a portfolio performing positively for a specific year. Clients report capital gains for a variety of reasons. Here are a few:

  • The client needed cash from the portfolio to pay for a new car and did not want to finance the purchase. While the stock market could be negative for the year, many of the investment positions in the portfolio may have been owned for many years. For example, assume someone owned a stock that was purchased in 2014 at $50 per share. Even though the stock is negative for the current year, the value in 2021 is now $120 per share. This means that any sale will have reportable capital gains of $70 per share. Again, the stock could be negative for the current year but, overall, the client has a rather large gain in the position to report on their tax return.
  • Another reason a client may have reportable capital gains in a year where the markets are negative has to do with owning mutual funds. Mutual funds can, and will, own positions where there has been growth in their holdings for a number of years. While the current year’s performance is negative, based on the larger gains and growth in the portfolio from prior years, the mutual fund may declare a capital gain distribution to the owners of the mutual fund. Tax-sensitive wealth advisers review these factors in selecting appropriate investments for their clients.

Having a capital gain distribution is not necessarily a negative item from an economic perspective. While tax sensitivity is a factor the economics of what is owned is considered first and foremost.

A client reports total dividend income of $50,000, of which $30,000 is considered qualified dividend income. A CPA reviewing the tax return may make a suggestion to adjust the portfolio where they only invest in stocks that pay qualified dividends to lower their tax bill.

This type of tax-planning advice may be considered managing a portfolio for tax reasons without consideration of the overall economics of the portfolio. It risks limiting investments to only stocks that pay qualified dividends.

Generally speaking, wealth advisers – even those who are tax-sensitive – will first consider risk and diversification to match a client’s overall longer-term goals and risk levels. Building a portfolio that limits investments to only those that pay qualified dividends in order to receive a better tax result may not create a well-diversified portfolio. This limitation could minimize or eliminate investments in certain smaller companies and international enterprises that may not necessarily qualify for the IRS definition of “qualified dividends” that are taxed as capital gains.

We like to consider the tax consequences of how we assist clients in building and managing their portfolios. In this specific example, a recommendation to use mostly stocks that pay qualified dividends has the potential to substantially limit diversification. Over longer periods of time, this can limit the client’s long-term performance in the boarder markets. Taxes are important, but the overall economics of building and managing a client’s total portfolio should remain the primary objective while trying to remain as tax sensitive as reasonably possible.

The client has a municipal bond portfolio. The tax preparer notices that many of the bonds were issued in states other than the resident state of Pennsylvania. A recommendation to the client is to consider the state-level tax implication, perhaps suggesting that the wealth adviser limit bond purchases to Pennsylvania-issues only.

Bonds play an important role in portfolios. One of their jobs is to provide a buffer when the stock markets are acting in a volatile manner. When looking for bonds to buffer the portfolio, you may be looking for ones that have a high credit quality. If the search is limited to only bonds issued in Pennsylvania, it may present a challenge to find enough to fill the municipal bond portfolio. By expanding the search to the country, a bond manager may find a larger inventory of high credit quality type bonds, and the yield may be better than what we may find by limiting the search to only those issued in Pennsylvania.

Keep in mind, the Pennsylvania 3% income tax rate is not a major tax impact, and as such may not be reason enough to limit the selection of high-credit quality bonds to only those available in the state.

This is one of the economic decisions that are considered in managing a bond portfolio for a client. Taxes are a factor, but when you make more even after paying the Pennsylvania state income tax of 3%, then buying the bonds that will work the best in the portfolio is the primary objective.

A client is purchasing a new home and is wondering if they should finance the house or any portion of the amount. Based on the now larger federal standard deduction, sometimes the advice delivered places significant weight on the mortgage interest and a lack of tax deduction. The advice to the client may be to avoid the mortgage since the interest paid will not lower the client’s tax liability.

The decision in how a client pays for a house, car, or any other larger purchase should consider factors beyond the tax deduction. Assume the client is purchasing a house for $500,000. They will have $200,000 of equity from selling their current home, which will be used as a down payment on the new home. They can borrow the balance of $300,000 at a rate of 2.8% for 30 years. As mentioned, the client uses the standard deduction on their federal taxes and the projected interest on the mortgage of $300,000 will not be high enough to allow them to itemize deductions. They will continue to use the standard deduction under the current laws.

Here are other considerations in deciding if a mortgage is appropriate for the client. The first that comes up is, “Where will the client obtain the $300,000 if they decide not to take a mortgage?” In this case, the client will need to obtain the cash from their portfolio. In looking at their portfolio to generate $300,000 of cash, there will be capital gains of about $40,000 to generate this amount of cash. It means that the client will need to pay additional capital gains taxes to pay cash for the house.

The client’s portfolio is about 80% invested in the stock market. The clients are 45 years old. Over the years, the portfolio performance has far exceeded the quoted mortgage interest rate of 2.8%.

While income taxes are a consideration when taking out a mortgage, the entire economics of the decision must be factored in as well.

After more thorough review and consideration, it appears that taking the mortgage will be a better option. This considers that the client would have additional tax liability for capital gains in order to generate $300,000 of cash needed. Finally, the economics of the portfolio’s past performance compared with the very low mortgage rate of 2.8% suggests that the client will make more than what they will pay in interest based on historical returns.

In the end, tax returns are a great source of financial information, but it is extremely difficult to use the return information as a sole source of evaluating how a client’s portfolio has performed.

The best way to service a client is to collaborate with different types of professional advisers, allowing a holistic consideration of all pertinent factors in making recommendations that are in the best interest of a mutual client. Wealth advisers should include the tax preparers and vice versa, to deliver the best advice possible.

Angie M. Stephenson, CPA, PFS, CFP, is partner, chief operating officer, and senior wealth adviser for Domani Wealth in Lancaster, Pa. She can be reached at angie.stephenson@domaniwealth.com.

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Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of PICPA officers or members. The information contained in herein does not constitute accounting, legal, or professional advice. For professional advice, please engage or consult a qualified professional.