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Tax-Aware Investing in Practice
by Kevin Kroskey, CFP®, MBA
Tax-aware investing means you can have your cake and eat it too. As I set out in the previous two articles, using a combination of long and short positions in your portfolio lets you pursue positive returns while lowering your tax bill. Below are two common situations where tax-aware investing can really make a difference.
The Big Sale
Suppose you are realizing a substantial gain, whether owing to the sale of your business or perhaps by diversifying a large amount of highly-appreciated stock you have accumulated over time (e.g. as a company executive).
As we know, it’s possible to use losses in your portfolio to offset your investing gains. But in the case of a substantial gain, how are you going to find a loss big enough while still coming out ahead overall? The answer is simple: you plan ahead.
Preparing the Way
Suppose you establish a long-short portfolio, going long on a basket of stocks you think will do well and shorting another basket you think will underperform. Let’s call this Step 1. If you make the right choices, you will experience a net positive performance over time. However, in any given year at least some of the short positions will generate losses.
For example, suppose $1m invested generates a 10% or $100k net gain. This consists of $400k in unrealized gains and $300k in realized losses. The result would be a $300k net capital loss for the tax year and a deferral of the $400k gain.
Losses can be carried forward to future tax years. After five years with the strategy, you can accumulate net losses of over $1.5m. These losses could now offset a large gain of $1.5m when you sell your business or sell highly appreciated shares.
The earlier you start, the more sizeable tax shield you can build. Also, if you have larger dollars to invest or add leverage to the long/short strategy, net capital losses can be even greater.
Can you hear the sound of champagne corks popping at the IRS? That’s right – me neither.
Income Taxes Too?
As we also mentioned in the initial article, tax-aware investing extends beyond your portfolio to what in tax terms is referred to as ‘ordinary income’ – business income or non-business income (wages, interest, IRA/401k distributions, etc.).
Let’s go back to the example of the married doctor couple in the first article. Suppose that their combined wage income is $1m. Let’s also assume they have ownership in a medical practice that generates an additional $500k in business income.
How can your investment losses be used to offset income outside the portfolio? Doing so first requires Step 1 with net capital losses being realized as previously described. In addition, Step 2 of the tax-aware strategy must be added, bifurcating tax attributes into either business income (ordinary income) or capital gains.
If properly structured and managed, the result of Step 1 and 2 can yield near-zero net capital gains/losses in a tax year but substantial business losses to offset ordinary income. Business losses first offset other business income and then non-business income up to a certain amount – $610k in 2024.
What does this mean for our couple? Well, if the couple’s Step 2 strategy resulted in business losses of $700k for 2024, here’s how it shakes out. They use the $700k as an offset first against their $500k of business income. Then the remaining $200k excess business loss is an offset to their wage income. Altogether, a $700k reduction saves $259k in federal taxes at their 37% rate!
How can this be possible? The keys are the long/short investing strategy, which is used in both steps. Then Step 2 utilizes a partnership structure that makes a tax election to be taxed as a ‘trader’ rather than an ‘investor.’ And rather than using stocks as in Step 1, the general partner executes the strategy utilizing swaps. Swaps can be structured with a large bank to have the same underlying economics as owning stocks outright but per regulations have different tax attributes.
These strategies and regulations they rely upon are complex and require a unique combination of deep expertise in investing, planning, and tax strategy, which is uncommon even in the professional space.
The long and short of it is, it may be time for a 2nd opinion and explore how these long-short, tax-aware investing strategies and their potentially substantial benefits may apply to you.
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Kevin Kroskey, CFP®, MBA is the Founder of True Wealth Design, providing “Accounting, Tax & Wealth Solutions To Help You Plan Smarter and Live Better.” This article is for educational purposes only. The strategies referenced apply to Accredited Investors or Qualified Purchases per SEC regulations. To explore how these strategies may apply to you, call or email kkroskey@truewealthdesign.com.
Opinions and claims expressed above are those of the author and do not necessarily reflect those of ScripType Publishing.