Certain maneuvers allow you to exit from a highly appreciated stock position while delaying or avoiding the tax. But look closely at the drawbacks.
How do you diversify away from a concentrated stock position without getting killed by capital gain taxes? There are a dozen ways to skin this cat.
A companion story, Smart Tax Strategies For Dealing With A Big Capital Gain, looked at several of the more commonly used strategies. Herewith are six additional recipes for deferring or avoiding taxes while exiting a stock market winner. Closing out this survey is a list of strategies that don’t work.
1. Join an exchange partnership.
This long-standing scheme has you contributing offending shares to an investment pool at the same time that other fat cats are contributing their stakes in other companies. You all get the investment results of the combined pool. Joining the partnership does not create a taxable event, but your low cost basis (and the risk of future capital gain taxes) remains.
Typically this poker game has a big ante, in the millions of dollars. You commit to staying put for a long time, like seven years.
The pool starts out with a fair amount of diversification by dint of having multiple contributions, and the diversification can be further improved by an arbitrage. The manager uses the contributed assets as collateral for a market-neutral collection of long and short positions in other stocks, then harvests losses from that pile. That allows him to slowly ease out of overweighted positions without creating a net capital gain for the partnership.
Does this work? The question goes to Blake Harrison, a CPA with CapWealth, a Tennessee firm that oversees the portfolios of prosperous families. His answer: Yes, but.
It does pass muster with the Internal Revenue Service, Harrison says. But the fees add up: The stockbroker pitching the plan will get one for creating the pool, another for managing it, potentially a third for the arbitrage play on the side.
Harrison had one client for whom the arrangement made sense despite the fees because this person was in his eighties and the step-up at death would mean an escape from capital gain taxes for his heirs. The amount in play was more than $40 million.
2. Contribute to a new ETF.
Mebane Faber, the entrepreneur behind the Cambria family of exchange-traded funds, makes the case for this diversification move, which relies on Section 351 of the tax code. Several of Faber’s ETFs, including one that is expected to start trading in two weeks, started out as tax deferral opportunities.
How the deal works: Before the fund launches, a collection of investors contribute appreciated assets in return for fund shares. They get instant diversification without triggering a capital gain realization, their cost basis in the contributed stocks being carried over as the cost basis in their ETF shares. After launch, the ETF operates like any other, with new shares being created and redeemed in response to demand and supply.
Post-launch, the tax dodge is not available on new assets. Customers who want to diversify and defer simply have to wait for the next new Section 351 fund.
The 351 exchange resembles the partnership exchange described in #1 above. But there are two big advantages to the ETF format. One, Faber says, is that the fees are lower—0.25% a year on Cambria US EW, the fund now underway. The other is that these ETFs, like any ETF, can use another tax loophole to evaporate their fund-level taxable gains by doing custom redemptions with middlemen. When the dust settles on these redemptions, the start-up investors still have the unrealized gains they started with, but the fund can exit concentrated positions without creating taxable gains of its own that have to be distributed.
What’s not to like? One big thing.
To qualify for a tax-deferred exchange, a start-up investor has to contribute a portfolio that is already somewhat diversified. The largest position can’t be more than 25% of the total, and the top five positions can’t account for more than half. So, to unload your $1 million of Nvidia shares you have to throw in another $3 million of other stocks. Now $4 million remains locked up in the ETF for as long as you want to defer capital gain tax.
Think about what this does to your portfolio costs. You didn’t need to diversify the $3 million; you could have slept at night leaving it in your brokerage account with a money management cost of 0.0%. In effect, you’re paying a 1% annual fee to avoid capital gain taxes on the Nvidia.
What’s your exit strategy? Perhaps a step-up at death to benefit your heirs. How many years elapse between now and when you get pushed onto the subway tracks? Fifteen? Multiply 15 by 1%. That’s almost as bad as a capital gain tax.
3. Get a forward contract.
A prepaid variable forward has you pledging appreciated stock for a loan and arranging to eliminate much of the risk in the stock by the way the loan repayment is structured. The risk reduction parallels what you get with an option collar, where the simultaneous purchase of a put and sale of a call eliminates exposure to extreme moves in the stock. The loan gives you the cash to create a diversified portfolio balancing that single stock.
Is this kosher? Yes, if it’s done right, says Andrew Whitehair, a CPA in the Cleveland area at tax and accounting advisory Baker Tilly. But he cites two problems.
Unlike a collar using publicly traded options, the variable forward contracts are bespoke deals with investment banks, available only to taxpayers with big positions. The contracts Whitehair has looked at involved tens of millions of dollars. Markups, built in and sometimes hard to discern, are not small.
The other matter is that the contracts typically go out only a few years. Then what? You could try to roll over into a new contract. That may call for coming up with a wad of cash. Or you throw in the towel, delivering the stock to terminate the loan and realizing the long-term gain you were trying to avoid.
4. Find an opportunity zone.
With this maneuver, you sell the appreciated stock and immediately invest the proceeds in an approved economically depressed area. That allows you to defer the capital gain tax for five years. Could make sense, Whitehair says, if you want to go into real estate. He recommends holding off until January 2027, when the recently liberalized rules for opportunity zones come into play.
5. Buy into a charitable remainder unitrust.
This philanthropic dodge is a variation on the charitable remainder annuity trust discussed here. Both are aimed at older investors.
With the annuity, you get a fixed dollar amount for as long as you live. With the unitrust you get a percentage amount. Example: At age 60, you contribute $200,000 of securities to an educational or other charity and get back an annual payment equal to 6% of your principal. The money is managed alongside the institution’s endowment; principal and payouts rise and fall with the market. At your death, the charity keeps the principal.
You get an immediate tax deduction equal to the discounted present value of the remainder interest. The payouts are taxable as a mix of ordinary income (such as from interest) and capital gain.
Colleges sometimes pitch unitrusts as a way to get retirement income much fatter than the 1.1% yield on the stock market. But getting income is a foolish reason to sign up. If you want to pull 6% a year out of your stock index fund, just collect the dividends and then sell 4.9% of your shares every year. You can leave what’s left to charity in your will.
But the unitrust could make sense if it allows you to ditch a risky, highly appreciated asset. The college immediately sells that stock, reinvesting in a diversified portfolio. You’ll owe tax on the capital gain you ducked, but only as the money is dished out. The tax damage, that is, is deferred and spread out.
6. Give to low-bracket relatives.
You could parcel out slices of an unwanted stock position as gifts to youngsters with small incomes and instruct them to sell. Not too young: The kiddie tax defeats this maneuver for a recipient who is either under 19 or under 24 and in school.
Beneficiaries who are old enough and have a taxable income (including the capital gain) below $48,350 pay no capital gain tax.
Be careful not to overdo this. You don’t want to be begging your granddaughter for money to cover your nursing home.
Now here are a few strategies that don’t fly:
- contributing appreciated shares to an IRA. Sorry, IRA contributions have to be in cash.
- unloading shares in an installment sale. Installment tax treatment still works on real estate but is banned for securities.
- giving to someone on his deathbed, with the understanding it will be willed back to you. Doesn’t work if the recipient survives less than a year.
- following the advice of someone promoting an offshore trust that will hide the gain. If President Trump reopens Alcatraz, there will be room for both of you.
