Recent choppiness aside, Wall Street has showered investors with profits during the pandemic. The flip side of that happy news is that stock gains face a wave of tax bills — a horizon some wealth managers are navigating by steering affluent clients through a strategy more common with hedge funds.
Last year, investors worried primarily about tax increases under the Biden administration's Build Back Better proposals. With those now stalled out, advisors are turning to the other side of the tax equation: the levies due when appreciated holdings are sold to take profits, adjust a long-term strategy or rebalance a portfolio that grew out of whack during the boom.
“Capital gains are a good problem to have, but an embedded gain is essentially an embedded tax liability,” said Amanda Lott, the head of wealth planning strategy at J. P. Morgan. “Tax efficiency is top of mind.”
In the two years since the COVID-19 pandemic began in early 2020, Americans added nearly $36 trillion to their wealth — a nearly 31% increase — as housing prices skyrocketed and stock markets boomed,
For affluent clients with appreciated gains in individual stocks, that means it’s time to take some profits and "de-risk" a portfolio so that it’s not over-laden with those shares — all while minimizing the tax bite on the gains.
“It’s the golden handcuffs of stock appreciation,” said Todd Jones, the chief investment officer of Gratus Capital, an independent advisory firm in Atlanta.
The long and the short of it
Enter an unlikely tool that’s more the province of hedge funds, not individual investors: short selling.
Shorting a stock means betting that it will fall in value. An investor borrows shares she think will decline in value and sells them. If the stock indeed falls, she scoops up the now-cheaper shares on the open market and returns them to the lender, pocketing the difference. And if the bet doesn’t work, she has a loss that can offset other gains.
Investors owe capital gains tax of a maximum 23.8% when they sell stock they’ve held for more than a year. Gains on assets sold after less than a year are taxed at the higher short-term capital gains rate, which is the same as an investor’s ordinary rate. Short sales typically throw off that higher rate.
So how can a higher-taxed profit create a lower tax bill? When it’s used in tandem with other, long-term investments. As Alpha Investments, a $1.6 billion asset management firm in Havertown, Pennsylvania,
Gains are taxed only when they move from being paper profits to being sold. That makes minimizing the so-called “tax drag,” or the amount of profit lost to taxes — an average 2%,
A hedge fund’s not-so-secret sauce
Jones likes hedge fund AQR Capital Management’s
The AQR method involves an investor holding all of her investments in a partnership, and not across separate brokerages or separately managed accounts, or custom wealth management accounts. Partnerships don’t themselves pay taxes, but instead pass on their collective gains and losses to the owner, who then pays taxes at ordinary rates, with the top now 37%, plus 3.8% for the Affordable Care Act. The point is that any losses or gains on one piece of the portfolio in the partnership affect the entire shebang’s passed-on returns.
Part of her portfolio typically includes a plain-vanilla S&P 500 index fund. But just like a hedge fund, the investor also shorts individual stocks in the index. Some of the tax magic comes thanks to IRS rules in which short-term losses first offset short-term capital gains. By the time the partnership distributes its profits to an investor, the money reflects that reduction in taxable income.
Jones said he was using the strategy to reduce the tax hit for clients who need to sell stock that has appreciated so much that it has injected extra risk into their investment portfolios by making them too big a piece of the entire puzzle. “You can bank losses in advance of the transaction,” he said — a balm to the tax hit of profit taking.
