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Another Tax Tip for MFI Investors

Update: this article has been updated to accomodate the "wash sale tax rules". Previously it did not incorporate this rule.

To follow up on previous articles explaining the Magic Formula tax strategy as well as how to handle holding periods, this article will present an addition to the strategy's selling rules that can may save you some money in taxes.

To quickly review, the Magic Formula strategy says to select a stock from the official screen and hold it for one year. If it is a winner, you sell after the one year mark to pay capital gains tax (15%) instead of income tax (up to 35%). If it is a loser, you sell before the one year mark to reduce your income tax burden.

However, there is often the case where you have a losing position after a year, but the stock is still on the MFI screen. In this case, especially if it is a strong company with durable competitive advantages (like MagicDiligence Top Buys), you may want to continue to hold the position for another year.

If this is the position an investor finds him or herself in, you may consider selling anyway and then re-buying after a 30-day "wash sale" period. This of course assumes that you are using a no-cost broker, which is what you should always be doing (MagicDiligence recommends Zecco, link below). Let's go through a couple examples to illustrate why this is the case.

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First, let's take an example where a MFI position lost money for the first year, and then posted a large gain during the second year, after which we decide to sell it. For this and the next example, we will assume the initial position was $10,000 and the investor falls into the 28% income tax bracket with a 15% capital gains rate. First, let's look at the result if the investor simply held the position for 2 years, without doing anything:

Position Held for 2 Years, No Sale
Initial Investment:$10,000
Value After 2nd Year:$12,000
Capital Gains Tax @ 15%:($2,000 * 15%) = $300

So, by holding the position, the investor would have owed Uncle Sam $300 in capital gains taxes on his $2,000 investment profit.

However, as mentioned previously, this investment actually lost money for the first year. What do things look like if the investor sold at the 1 year mark and then then bought the stock again, after a 30-day wash sale period? Let's see:

Position Sold after 1 Year, Repurchased, Sold after 2nd Year
Initial Investment:$10,000
Value After 1st Year:$9,000
Income Tax Savings @ 28%:(-$1,000 * 28%) = -$280
Value After 2nd Year:$12,000
Capital Gains Tax @ 15%:($3,000 * 15%) = $450
Net Taxes Paid:($450 - $280) = $170

By selling the losing position after the 1st year, repurchasing, and then selling slightly after the 2nd year was up, the investor would have paid a net $170 in taxes to Uncle Sam, compared to $300 by simply holding. That's a significant 43% savings in tax dollars!

To summarize, Magic Formula investors should consider selling losers right before the 1 year anniversary. If it's a stock that is still on the MFI screen and has Top Buy characteristics, you can then turn around and repurchase it after a 30-day period.

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