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The Key to Tax-Aware Investing
by Kevin Kroskey, CFP®, MBA
In our last article, we talked about how investors can use their portfolios not just to generate returns, but also minimize taxes. While the strategy may be varied and complex in practice, it comes down to one key concept, which will be the focus of this article.
Beyond “long-only”
Buying a stock you think will go up is called “going long” in investing parlance. It’s the most common way to invest.
By contrast, “going short” is a way to make money out of a stock you think will go down in value. Rather than buying the stock, you borrow it from someone, sell it, and then at an agreed future date buy it at the market price and give it back. If the price has gone down in the meantime, you keep the difference.
Shorting is a game-changer for portfolio management. Compared to a long-only strategy, it greatly increases the potential opportunities to make a profit, especially when the market is turbulent. It also opens up significant potential for tax benefits, as we’ll see.
Extending the portfolio
First, let’s talk about how to use short positions effectively.
Imagine you have a portfolio of stocks you think will grow. Now, imagine you add a number of short positions for stocks you think will underperform. Selling these stocks short provides you with money that you can use to buy more of the stocks you think will do well.
This is called an “extension strategy.” Here is a comparison of the two portfolios.
Clearly, if the “long” stocks go up as expected, and the “short” stocks go down as expected, you are in great shape. But as any professional investor knows, it is the unexpected that typically ends up happening, and this is where the strategy really comes into its own.
A win-win strategy
Very few stocks are independent of the broad market, and the broad market can move up and down unexpectedly. For example, if there is a surprise economic event such as a banking crisis, the broad market will be affected and not just bank stocks.
Having a combination of long and short positions can protect you against this market volatility. If the market goes up, your long positions increase in value. If it goes down your short positions benefit.
But what about the flipside – won’t you also likely experience losses in either your short or long positions? Not only is this likely, but it is welcome!
As we discussed in the last article, a steady stream of losses, generated within a portfolio that – overall – generates positive returns, represents the ideal scenario from a pre and post-tax perspective.
In other words, a long-short portfolio helps both to smooth returns and increase after-tax gains – all at the same time. And of course, if the long and short positions are well chosen, you can expect to earn a higher-than-average return – also known as “generating alpha.”
After-tax boost
As most investors are aware, losses in one part of the portfolio can be used to offset gains elsewhere in the portfolio, meaning lower capital gains taxes. You can also accumulate these gains over time to offset large tax events (such as the sale of a business).
But it doesn’t stop there. In a tax-aware, limited partnership investment, losses can be recognized as business losses, and you can use them to offset other business income or non-business income such as wages, up to a specific limit ($610,000 in the case of a married couple in 2024).
Long-only portfolios that do well unfortunately do not generate much in the way of capital losses. This means that you have to choose between portfolio gains or tax benefits. By adding short positions to a portfolio, however, you can ensure a steadier stream of losses without harming your overall returns.
What this means for you
As hinted in the introduction, actually implementing an extension strategy is a complex process. The success of the strategy depends on the right securities being chosen in the first place. Furthermore, the portfolio should be designed in such a way to reflect the investor’s likely tax obligations, so that losses are – as far as possible – timed to coincide with corresponding gains.
In the next article, we’ll examine some concrete examples of how investors can use long-short strategies to reduce their taxes.
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Kevin Kroskey, CFP®, MBA is the Founder of True Wealth Design, a wealth management firm with deep expertise in retirement, tax, and investment planning, helping successful families and individuals Plan Smarter and Live BetterTM
Opinions and claims expressed above are those of the author and do not necessarily reflect those of ScripType Publishing.