LOS i: Explain the benefits of tax loss harvesting and highest-in, first-out (HIFO) tax lot accounting.

Q1. Chris Manning, CFA is advising a client concerning harvesting tax losses. The client expects that her tax situation will not change over the next few years. She asks about incurring a given loss in the current year or waiting a few years to incur the loss. She asks how the decision will affect the total taxes she pays over her life. Manning should advise her that:

A)   she should not incur the loss this year because the HIFO principle means her total taxes will be higher if she incurs the loss this year.

B)   the total tax bill over her life will not change if her tax status does not change.

C)   she should incur the loss this year because the HIFO principle means her total taxes will be lower if she does.

Q2. The main benefit of tax-loss harvesting is:

A)   saving on future taxes.

B)   saving on current taxes.

C)   reducing both current and future taxes.

Q3. When highest-in-first-out (HIFO) accounting is allowed, it is advisable for:

A)   an investor to liquidate the portion of a position with the lowest cost basis first, thereby minimizing current taxes.

B)   an investor to liquidate the portion of a position with the highest cost basis first, thereby minimizing future taxes.

C)   an investor to liquidate the portion of a position with the highest cost basis first, thereby minimizing current taxes.

LOS i: Explain the benefits of tax loss harvesting and highest-in, first-out (HIFO) tax lot accounting. fficeffice" />

Q1. Chris Manning, CFA is advising a client concerning harvesting tax losses. The client expects that her tax situation will not change over the next few years. She asks about incurring a given loss in the current year or waiting a few years to incur the loss. She asks how the decision will affect the total taxes she pays over her life. Manning should advise her that:

A)   she should not incur the loss this year because the HIFO principle means her total taxes will be higher if she incurs the loss this year.

B)   the total tax bill over her life will not change if her tax status does not change.

C)   she should incur the loss this year because the HIFO principle means her total taxes will be lower if she does.

Correct answer is B)

Under the indicated conditions, i.e., the tax rate not changing in the foreseeable future, the total tax burden will be the same. It is better to take losses early only to reap the gains earlier and be able to invest the gains earlier.

Q2. The main benefit of tax-loss harvesting is:

A)   saving on future taxes.

B)   saving on current taxes.

C)   reducing both current and future taxes.

Correct answer is B)

Although tax loss harvesting saves on current taxes, the apparent tax savings in a given year are misleading. This is because when the security is sold and the proceeds are reinvested, the cost basis of the new, replacement security is the low sales price of the old security. In other words, when the old security is sold, the cost basis for future taxes is reduced, thereby resulting in higher taxes in the future.

Q3. When highest-in-first-out (HIFO) accounting is allowed, it is advisable for:

A)   an investor to liquidate the portion of a position with the lowest cost basis first, thereby minimizing current taxes.

B)   an investor to liquidate the portion of a position with the highest cost basis first, thereby minimizing future taxes.

C)   an investor to liquidate the portion of a position with the highest cost basis first, thereby minimizing current taxes.

Correct answer is C)

If an investor has accumulated a security position through a series of trades each occurring at different points in time and at different prices and if HIFO accounting is allowed by the government, the investor can liquidate the portion of a position with the highest cost basis first. This minimizes current taxes. As with tax loss harvesting, the total taxes over time are unchanged with HIFO accounting.

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