A bank never wants to lose money, but there can be an upside to doing so if the loss creates a deferred tax asset, which allows a company to offset future income with previously unclaimed losses for the purposes of calculating federal income taxes.
These seemingly esoteric assets are both easy to understand and very important right now for two of the nation's biggest banks: Bank of America (NYSE: BAC) and Citigroup (NYSE: C).
Defining deferred tax assets
Deferred tax assets generally don't play a major role at consistently profitable companies. That's because they tend to materialize when a company reports more in losses than it's able to claim as a deduction on its income statement in a given year.
The unused portion of losses can be carried forward to offset a bank's net income in future years. It's the value of this carry-forward that's captured by a bank's deferred tax assets, which are recorded as intangible assets on the balance sheet.
Image source: Getty Images.
One quality of deferred tax assets is particularly important to keep in mind: They expire if not used after a set amount of time, often 20 years. This matters because a bank that isn't able to use all of its deferred tax assets before they expire must write the remaining value off, reducing shareholders' equity.
This also matters because changes to the corporate income tax rate impact the value of deferred tax assets. When rates go up, these assets increase in value, as they shelter a larger share of income. But when rates go down, so too does the value of deferred tax assets, as a bank may not be able to realize the entire benefit before the statute of limitations expires.
Bank of America and Citigroup's deferred tax assets
The relationship between the corporate income tax rate and the value of deferred tax assets is especially relevant right now, given Trump's proposed plan to cut corporate income taxes from a top rate of 35% down to 15%.
Make no mistake about it, a tax cut this significant would be a boon to Bank of America and Citigroup, both of which rank among the 10 biggest taxpayers on the S&P 500. Based on its income and effective tax rate last year, Bank of America's tax liability would have declined by approximately $3.5 billion. Citigroup's would have dropped by around $3.2 billion.
Image source: Getty Images.
But the catch is that both of these banks would also likely be forced to write off a portion of their unusually large deferred tax assets, which stem from their outsized financial crisis-related losses. At the end of last year, Citigroup reported $47 billion worth of net deferred tax assets, while Bank of America's are valued at $19 billion.
According to analysts, Trump's proposed tax cut could translate into anywhere from a $6 billion to $12 billion charge-off at Citigroup, and around $4 billion at Bank of America. That's a lot of money, regardless of these banks' multi-trillion dollar balance sheets.
Don't get me wrong, Bank of America and Citigroup would still benefit immensely from the annual tax savings of a lower rate, though they will first have to contend with the fall in value of their deferred tax assets.
10 stocks we like better than Bank of AmericaWhen investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*
David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Bank of America wasn't one of them! That's right -- they think these 10 stocks are even better buys.
Click here to learn about these picks!
*Stock Advisor returns as of April 3, 2017