Tax Issues

Squeezing out more tax efficiency from my portfolio

My portfolio is currently allocated as follows:

  • US LargeCap 11%
  • US SmallCap 8%
  • US REITs 4%
  • US Timber REITs 4%
  • US MLP (PIK dividends only) 4%
  • INT EAFE 20%
  • INT Emerging Market 11%
  • PreciousMetal Equity 5%
  • Fixed Income 33%

The ranking of the asset classes, in terms of tax efficiency (based on historical dividends), are as follows (most tax efficient at the top):

  • US MLPs EEQ & KMR (with PIK paid-in-kind dividends only) : 0% taxed.
  • US Timber REITs PCH, PCL & RYN: 0% taxed due to my enormous capital losses accumulated (see related post “Tax-Free Dividends from Timber REIT Investing” HERE).
  • US SmallCap (IJS) : distribution yield ~2.0% will be taxed.
  • PreciousMetal Equity (GDX) : distribution yield ~2.0% will be taxed.
  • US LargeCap (IWB) : distribution yield ~2.8% will be taxed.
  • INT EAFE (VEA) : distribution yield ~4.0% will be taxed.
  • INT Emerging Markets (VWO) : distribution yield ~5.0% will be taxed.
  • Least efficient : US REITs and Fixed Income.

The commonly sprouted ‘wisdom’ of putting International equities and emerging market equity in the taxable account so as to get the foreign tax credit is coming back to bite me now (and probably in future as well) with huge 4% (VEA) and 5% (EEM) distribution yields. This is ironic considering that VEA is simply just another class of Vanguard’s Tax-Managed International stock fund.

On the other hand, US SmallCap Value has a sub-3.0% yield but ‘experts’ usually would recommend putting this asset class into tax-deferred accounts.

Anyway, based on this analysis, I have been re-directing new money in the taxable account to the most tax-efficient assets listed above.

“Tax-free” Dividends from Timber REIT investing

Due to the recent bear market, I harvested a huge amount of capital losses (six-digit figure) which I can use to offset against capital gains and income in future years. The offset against capital gains is uncapped, but that against income is capped at $3000 a year.

With that in mind, investments that primarily throw off capital gains have become much more attractive to me (since my previously harvested tax-losses can be used to completely offset against these distributions, i.e. essentially tax-free). There are however very few investments that intrinsically throw off capital gains rather than dividends. (Note: Funds that actively turn over their portfolio, hereby producing capital gains, do not count.)

Nevertheless, there is a class of investments that do intrinsically produce capital gains. These are timber REITs. Generally, the dividends that timber REITs distribute are considered as long-term capital gains, instead of the more common dividend income distributed by general REITs.

The three most common timber REITs, all of which only produced distributions that were classified as capital-gains last year, are

I always held an interest in timber investing. Several years ago, I had invested in PCL for a while before forgoing it. Given the new background scenario, I tweaked my portfolio last month to allocate a small portion into the above three timber REITs. (Disclaimer: Please do your own due diligence if you want to invest in the above securities.)

I shall not elaborate on the pros and cons of timber investing in this post. Instead, I shall leave the links to various discussions / resources on timber investing:

Introduction to investing in timber securities
Timber ETFs…Without the Timber?
Finding the Perfect Dividend Stock
Timber Investing: My articles on ETFs and REITs
Timber for the Individual Investor

Sequence for ETF tax-loss harvesting

A recent question on the Bogleheads forum was Exact sequence of an ETF TLH transaction:

Is there a recommended method of doing a TLH? I tend to like to TLH on market downturns if at all possible. Currently I start with the ETF that I would like to sell. I look at the bid/ask, and I generally choose the higher “ask” price to set as my limit order. Even though I’ve chosen a down day to sell this ETF, obviously I would like to get on the higher side of the bid/ask spread since I am selling. The moment the sale goes through I start working on buying the replacement ETF. At this point I do not like to miss the opportunity to complete the sale due to greed. I put my limit order at exactly the lower “bid” (not the higher ask) price. I observe it closely for a few minutes to half an hour to see what it’s doing. If it looks like it’s veering upwards I will raise my limit to the current bid price. If after a while it looks like I’m going to miss the boat, I simply raise my limit order to the ask price instead of the bid. Generally this will execute the order. Most of the time I execute both orders within a few minutes to half an hour without being hosed too serverely.

I thought it would be interesting to hear what people have to say. Anyway, the following is what I do:

I enter the two orders first, but with out-of-range prices using limit orders. I open two windows — one for the purchase, one for the sale.

At the point when I want to execute the TLH, I modify one of the existing order to the price which would complete the transaction. As soon as I verify that the order is completed, I modify the price of the second order (modifying an order’s price is much faster than entering the complete order).

Depending on the ETFs, sometimes I do the purchase first and sometimes I do the sale first. Generally, I like to complete the transaction with the lower liquidity / volume ETF first.

My preference for completing the transaction on the ETF with lower liquidity / volume first is because if I had done it the other way round, I might be unable to complete the second transaction at a reasonable trading transaction cost (due to undesirable bid-ask spread).