What I Wish Every CPA Knew
My entire career has been spent working for CPAs or public accounting firms. I have sat in year-end meetings where my colleagues talk through which expenses their business clients could add before December 31 to bring their income down. Working with tax professionals, I have seen and helped implement strategies for clients: 401(k) and profit-sharing plans, cash balance plans, charitable bunching through a donor-advised fund, pass-through entity tax elections, cost segregation studies and bonus depreciation, Section 179 expensing, putting the owner’s children on payroll, Roth conversions in a low-income year, etc. Each one is a fantastic tool in the proverbial belt.
Still, several times I have mentioned tax-aware long-short or 130/30 strategies and been met with blank stares from experienced CPAs. Some have never heard of direct indexing, the idea it grew out of. There is no shame in that. Although the strategy has been around for a while and is familiar to many advisors, it is an investment strategy first and foremost, so it makes sense that it may not cross the path of a CPA who is not working in wealth management. For business owners and executives with realized or upcoming capital gains or concentrated low-basis stock, this tool is worth knowing.
Start with direct indexing
Direct indexing means owning the individual stocks in an index inside a separately managed account, instead of owning an index fund. Because the client owns each stock, the manager can sell the ones that have dropped, book the loss, and buy a similar company so the account still tracks the market. The replacement can’t be the same or a substantially identical stock bought within 30 days before or after the sale, or the wash-sale rule (Section 1091) disallows the loss.1 The harvested losses then offset capital gains elsewhere on the return.
The limit is that the losses dry up. In a rising market, most positions climb above what was paid for them. After a few good years there is little left to sell at a loss, and the account starts to look like an index fund with a low basis.
Adding the short side
A tax-aware long-short strategy starts from the same idea and adds two things: modest leverage and short positions. Selling short means borrowing a stock and selling it, then buying it back later. The position makes money if the stock falls and loses money if it rises.
Say a client puts $1 million into the account. The manager buys about $1.3 million of stocks it expects to do well and sells short about $300,000 of stocks it expects to lag. The two sides net to about $1 million of market exposure, so the account should move roughly with the market. This mix is often called 130/30, and managers offer a range of them, some well beyond it.
The losses now come from both directions. Tax-aware long-short strategies may create additional opportunities to realize capital losses from both long and short positions, although the availability, timing and tax character of those losses will depend on the particular transactions and the investor’s circumstances. In any year, even a strong one, some stocks go up and some go down. That spread between winners and losers feeds the harvesting, so the account is designed to keep finding losses in the same rising markets where direct indexing runs dry.
The manager also watches the character of what gets realized. Losses are taken quickly, while they are short-term, and gains are held where possible until they qualify as long-term. Research published in the Financial Analysts Journal found that in these strategies the long positions tend to realize long-term gains taxed at lower rates, while the short positions tend to realize short-term losses that can offset short-term gains elsewhere.2
A wealth-building strategy first
I think of tax-aware long-short as a wealth-building strategy, and the tax losses as a byproduct of the work. The stock selection in these strategies is usually systematic. It leans on traits that academic research has linked to higher long-term returns, such as value (stocks that are cheap relative to their fundamentals) and momentum (stocks with strong recent performance).3 The manager buys more of what scores well and shorts what scores poorly.
That short side first matters for the return of the investment and has a sweet tax-loss harvesting perk. A long-only manager who dislikes a stock can, at most, own none of it. A long-short manager can bet against it. Short positions give the manager an additional opportunity to seek returns from security selection, which the industry calls alpha, but they can also detract from returns when those investment judgments are incorrect. There is no assurance that the strategy will generate positive alpha or outperform a long-only portfolio or market index.
CPAs are rightly wary of anything that exists only for its tax result. I must confess I was leery of them too. I was introduced to these strategies years before I even considered them for my clients. Every loss in this account comes from a real position with real money at risk, inside a portfolio that is trying to grow. Many year-end strategies lower taxable income by putting a dollar somewhere specific, such as a retirement plan, a charity or new equipment. This one works on money the client has already decided to invest.
Where it fits
The losses are capital losses. They offset capital gains in full, but only $3,000 a year of ordinary income, or $1,500 if married filing separately, with the rest carried forward to later years.4 So this will not replace a cash balance plan for a business owner whose income is all ordinary. It does the most good for a client with capital gains on the way: the sale of a business or a rental property, an executive with a large position in company stock, or a portfolio of funds that throws off gains every year. Losses banked in the years before a sale can sit on the return and wait for it. Some in the industry call it capital gains insurance, though the amount of losses is never guaranteed.
Over time the harvesting lowers the account’s basis, so much of the benefit is a deferral. If the client sells everything, the gains come due. The cleanest exits are ones CPAs already use. Highly appreciated shares held more than a year make good gifts to a donor-advised fund, which pairs well with charitable bunching, and shares held until death receive a step-up in basis (Section 1014).5
The risks
Leverage and shorting add risk. A short position can lose more than was put into it, and a stretch where the longs fall and the shorts rise hurts on both sides at once. The account can drift from the market, sometimes for long stretches, and a client who compares it to the S&P 500 every quarter may struggle with the tracking error. The extra return the manager is aiming for may never show up. Fees run higher than an index fund, and there is a borrowing cost on the leverage.
There are tax tripwires too. Trades in the client’s other accounts can create wash sales the manager cannot see, so the accounts need to be coordinated. Tax law can change. These strategies also usually need a sizable taxable account, and they are significantly more complex.
When a client has a sale on the horizon or a large taxable account sitting in index funds or concentrated, low-basis positions, tax-aware long-short is worth a conversation. There are many strategies and tactics available to business owners and executives, and this one deserves its place in the tool belt.
Author
Clayton Johnson, CPWA®, CFP®
Clayton Johnson is a Wealth Advisor at Savvy with more than 10 years of experience helping business owners, executives, and affluent families navigate complex financial decisions. His work brings together tax planning, investment strategy, estate and wealth transfer planning, executive compensation, and broader financial planning.
Sources
1. 26 U.S.C. § 1091, Loss from wash sales of stock or securities. https://www.law.cornell.edu/uscode/text/26/1091
2. Clemens Sialm and Nathan Sosner, “Taxes, Shorting, and Active Management,” Financial Analysts Journal 74, no. 1 (2018), DOI 10.2469/faj.v74.n1.1. https://rpc.cfainstitute.org/research/financial-analysts-journal/2017/taxes-shorting-and-active-management
3. Clifford S. Asness, Tobias J. Moskowitz and Lasse Heje Pedersen, “Value and Momentum Everywhere,” Journal of Finance 68, no. 3 (June 2013): 929-985, DOI 10.1111/jofi.12021. https://pages.stern.nyu.edu/~lpederse/papers/ValMomEverywhere.pdf
4. Internal Revenue Service, Topic No. 409, Capital Gains and Losses. https://www.irs.gov/taxtopics/tc409
5. 26 U.S.C. § 1014, Basis of property acquired from a decedent. https://www.law.cornell.edu/uscode/text/26/1014
Disclosures
This material is provided for informational and educational purposes only and is not intended to constitute individualized investment, tax, accounting or legal advice. Tax rules are complex and subject to change, and their application depends on an investor’s individual circumstances. Investors should consult their tax and legal advisers regarding their specific situation.
Tax-aware long-short strategies use leverage and short selling, which can magnify losses, and they are not suitable for every investor. Tax results depend on each taxpayer’s circumstances and on current law, which can change. All investing involves risk, including the loss of principal.
All advisory services are offered through Savvy Advisors, Inc. (“Savvy Advisors”), an investment advisor registered with the Securities and Exchange Commission (“SEC”). Savvy Wealth Inc. (“Savvy Wealth”) is a technology company and the parent company of Savvy Advisors. Savvy Wealth and Savvy Advisors are often collectively referred to as “Savvy”.
Clayton Johnson is an investment advisor representative registered with Savvy Advisors, Inc. (“Savvy”). All investment advisory services offered by Clayton Johnson are offered through Savvy. Pillar Capital is an independent marketing brand name used for advertising and marketing purposes only. Pillar Capital and Savvy are not related or affiliated. For more information about Savvy, please visit our website.
Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® (with plaque design) in the United States to Certified Financial Planner Board of Standards, Inc., which authorizes individuals who successfully complete the organization’s initial and ongoing certification requirements to use the certification marks.