Tax-Rate Arbitrage: Realization of Long-Term Gains to Enable Short-Term Loss Harvesting

Abstract

We look at an enhanced loss-harvesting strategy, tax-rate arbitrage, which exploits the differential between short- and long-term tax rates. Our study relies on ATBAT, an After-Tax Back-Testing Analysis Tool that lets us examine tax-managed strategies over numerous historical periods. For the ideal tax-rate arbitrage investor, one who is subject to federal only tax rates, who has a long horizon and a planned liquidation date, and who launches the strategy from all cash, tax-rate arbitrage generated an average of 0.78% in excess after-tax active return at a 10-year horizon relative to a standard loss-harvesting strategy. Other investors with different profiles may benefit from tax-rate arbitrage but typically to a lesser extent.

Keywords: tax-rate arbitrage, loss harvesting, tax-managed strategies, tax-rate differential, gains realization, ossification

JEL Classification: G11, G18, H24