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Some readers have asked about the Magic Formula's handling of capital gains and income tax rules. I wanted to take a moment to explain why Joel Greenblatt has different rules for selling winners and losers and illustrate how it can enhance returns.

First, let's revisit the strategy's prescription for selling positions. Those following the Magic Formula strategy are supposed to hold any positions for one year, at which time the position can either be held for another year (if it is still in the official screen), or sold (if it is not in the screen). However, the rule is slightly different depending on whether the position is a winner or a loser. For winners, it is advised to sell after one year from the purchase (even a day after is acceptable). For losers, you want to sell them before the one year anniversary of the buy. There is a good reason for this and it has to do with the tax code for investments in the U.S. For those outside the U.S., the laws of your country may or may not be similar.

The federal government liberally uses the tax code to promote behavior it deems favorable to the public good. This can be seen in many places, such as deductions for hybrid vehicles or installing energy efficient windows. But the government also encourages "long term" investment holding periods through something called the capital gains tax. Income from sold investments is categorized into one of two categories: income (if the investment was held for less than a year), or capital gains (if held for more than a year). So, one year is considered "long term" by the government.

The rub is that the capital gains tax rate is always lower than the income tax rate. For families earning over $65k per year, the minimum income tax rate is 25% while the capital gains rate is 15%. Let's take two simple examples, one a winning investment and one a loser, and show how selling at different periods effects the final amounts realized. Let's start with a winning investment, where the gross gain was $1,000:

Gross Gain:	$1,000
Tax @ 25%:	$250
Net Gain:	$750
Tax @ 15%:	$150
Net Gain:	$850

Pretty simple, right? Selling the winning position after the 1 year anniversary netted you an extra $100, or 10%. Not too shabby! It works in reverse for a losing position. Here's that breakdown, where the gross loss was $1,000:

Gross Loss:	-$1,000
Tax Benefit @ 25%:	+$250
Net Loss:	-$750
Tax Benefit @ 15%:	+$150
Net Loss:	-$850

The same thing, only in reverse. Selling before the 1 year was up saved you $100 in taxes. The sell strategy for losers is even more advantageous when you consider that the U.S. only allows you to report $3,000 in capital losses a year, while income losses can accrue to the actual value. The point of investing, and particularly MagicDiligence, is to avoid these kind of losses, but the strategy handles them efficiently if they do occur.

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