From Short Positions to Section 351: Navigating Modern Tax Mitigation

There is a lot of news about long/short equity strategies being used as an effective tax mitigation strategy for investors.  These processes seek to generate losses through the use of leverage by establishing long positions (say 130% to 175% notional exposure) and offset them with short positions to create a net long market portfolio.  Perform loss harvesting like any other direct index product, but in an up market many of the short positions can also be sold at a loss. More losses to realize = more capital losses to offset capital gains. Just make sure the long and shorts don’t converge too much (ideally the opposite happens and you make some extra return).

This sounds really good on paper.  In practice? TBD.

What’s not known in advance is what will be involved to tax-efficiently unwind these structures and the impact of portfolio drift over time.  There are also estate planning considerations when dealing with short positions – they may not get a step-up in basis.

There are also expenses (leverage requires borrowing money from the custodian) and costs to “borrow” equities to sell them short.  The benefit is the likely generation of additional capital losses to offset outside capital gains.  This can reduce near-term tax costs when selling a concentrated equity position (or in the case of large outside gains).  But of note, in addition to borrowing costs, these strategies may have elevated fees vs. lower cost alternatives (either direct indexing or using ETFs).  Given current interest rates, those fees can add up quickly.

It is our belief that in many cases simpler is better.  As the portfolio ossifies and the ability to generate capital losses is minimal to nonexistent going forward, Section 351 exchanges can come into play.  These ETF seeding exchanges preserve cost basis (while allowing for diversification), creating an opportunity for even longer tax deferral.  A series of exchanges can be used to diversify highly appreciated single stock positions (slowly and subject to a series of tax and concentration rules which are beyond this post). And remember – an easy way to see a lower tax bill in a concentrated stock position is for it to drop in value significantly.  So hedging and proper risk management is critical.

Torren Management has experience in these areas.  Happy to discuss further.