By Investment Research
Over the past ten years, the longest bull market on record has left many fortunate investors with substantial gains. Equity markets have annualized at over 16.5% since the lows of March 2009. Had an investor put $10,000 into the S&P 500 at that time, the investment would now be worth over $50,0001. Even more staggering, if an investor had owned shares of recent high-flying tech or FAANG stocks, that same investment would be worth exponentially more. A $10,000 investment in Amazon, for example, would have yielded more than $250,000 over the same time period1. Equity markets have certainly had a great run, however, as concerns grow around volatility and a slowing global economy, investors with concentrated stock positions may want to consider reducing those positions to lock in profits and reduce their overall risk.
Source: Bloomberg, Simon Quick Research
Diversification is a foundational concept in financial planning and asset management. The objective of diversification being that spreading your proverbial eggs across several baskets increases the odds of successfully achieving long-term investment goals and reduces the chances of sharp, and permanent losses of capital. Over the past three decades, approximately 65% of Russell 3000 stocks have underperformed the index2, and even the strongest of companies are not immune to being lumped into that group over time. Take, for example, the bankruptcies of once dominant companies such as Sears, Bethlehem Steel, WorldCom, and Lehman Brothers.
This isn’t just a story for investors. Senior executives and retirees of public companies may find that a significant portion of their net worth is tied to a single stock with a low cost-basis. During pronounced equity market gyrations, planning for one’s financial future becomes incredibly difficult, and thus there is a need for diversification. Of course, one could reduce single company risk by simply selling out of the concentrated position, but that would result in a large capital gains tax bill. A 23.8% tax bill, for instance, would require an approximate 31.2% return just to break even. Fortunately, there are several strategies that you can employ to either efficiently diversify your portfolio or liquidate the position in a tax-efficient manner.
Pros: Tax free transfer of stock or assets, potential reduction of gift value from income taxes, simple process
Cons: The gifting party gives up ownership of the asset
Perhaps the simplest, and most efficient, way to manage large gains is through the process of gifting to charitable organizations. If a stock, or asset, is donated to a charity, there is no tax paid at the time the gift is given. Investors are also able to deduct the current market value of the gift from their income taxes up to certain limits so long as the stock or asset has been held for one year or more. For charitable organizations that may not have the ability to take donations in forms other than cash, Simon Quick can help clients establish donor advised funds. These vehicles allow for clients to make regular, or one time, contributions of cash or stock that can be granted to their designated charities over time, while still receiving the tax advantages immediately at the time of contribution. Assets within donor advised funds are able to grow and be sold tax-free making them a preferred tool in helping to efficiently maximize the amount one is able to give to charitable causes.
Alternatively, one may choose to gift stock, or assets, to a family member. In this situation, as long as the gift is below the annual exclusion amount ($15,000 per individual for 2019 and 20203), the gifting party will pay no tax, but basis will transfer with positions and the receiving party will still need to pay tax should there be a sale in the future. In many instances, there are still benefits as the gifting could shift the capital gains into a lower tax bracket of the receiver. Of course, the downside of gifting to charity or others, however, is that the stock or assets gifted no longer remain the property of the original holder.
Opportunity Zone Funds
Pros: Reduction and deferral of taxes, profits on fund gains are tax free if partnership interest is held for 10 years
Cons: Does not fully eliminate realized taxes, limited window to reinvest gains, long fund lock up period, investment-related risks
The United States Tax Cuts and Jobs Act of 2017 allows for investors to take advantage of the opportunity zone investment program. This program incentivizes investors with unrealized capital gains to realize those gains and subsequently roll them into investments in real estate or businesses located in underdeveloped areas by offering attractive tax benefits. There are two primary benefits to investing in an opportunity zone fund.
- First, investors can defer their tax bill until their 2026 tax filing, and reduce the bill by 10-15% of the amount invested.
- Second, any profits generated by the opportunity zone fund are tax-free so long as certain criteria are met, and the investment is held for at least 10 years.
Opportunity zone funds can be great options for those with appreciated stock that the holder no longer wants. Additionally, they can provide compelling after-tax return potential when compared to traditional real estate investments not utilizing the program. For a more in depth look at opportunity zone investing please see our whitepaper entitled “Making Good Become Great: Investing in Opportunity Zones.”
Source: Simon Quick Third Party Manager Research
Tax Managed Strategies
Pros: Wind down concentrated position by using tax losses from other assets, retain market exposure
Cons: Additional cash is needed on top of the appreciated stock, multi-year process
The IRS generally allows for investors to offset realized gains with realized losses for tax purposes. Typically, a process known as tax loss harvesting occurs around year end, during which time investors and advisors will look through portfolios to see which positions should be realized at a loss in order to offset taxable gains and income from other profitable investments. This is a useful technique, however in many instances investors may not have enough losses within a portfolio to offset the potential tax consequences of a full sale of an appreciated position. This is especially prevalent in times of a long bull market run the likes we have seen over the last decade. In such a situation, utilization of an active tax management strategy may be advantageous.
Active tax management strategies overlay index-tracking portfolios with tax loss harvesting. Investors would provide a manager with an appreciated stock position as well as cash. The cash contribution is used to purchase additional stocks with the goal of replicating an index. As certain stocks within the replicated index lose value, they are sold and replaced with stocks that have similar characteristics. The sales generate tax losses that can be used to offset taxable gains as portions of the appreciated stock are subsequently sold over time. Being able to fully liquidate out of a position can take several years and the exact amount of time needed will vary depending on the amount of stock contributed relative to cash, the basis of the contributed stock, and how flexible an investor wants to be on tracking error versus a benchmark index.
Pros: Highly liquid, modest downside protection to the security, no lock up of capital, customization to best suit investor situations
Cons: Multi-year process to liquidation, limits further stock appreciation
Options give holders the right, but not the obligation, to buy or sell specific securities. The option seller benefits from receiving a premium to offer that right to the holder. This is not too dissimilar from an insurance policy, or pre-purchasing tickets for a future event at a discount. We don’t recommend individuals trade options on their own, unless they are experts and are actively monitoring their positions. If executed conservatively and thoughtfully by a professional manager, however, an option strategy can be a useful tool in the context of tax-efficiently liquidating positions and reducing risk. A simple approach to this strategy is to sell call options on a stock an investor wishes to liquidate over time. Depending on the direction the underlying stock moves, the options will either make or lose money. If the call options are profitable, the stockholder can sell a portion of the underlying position and use the premiums earned from writing the call options to pay the tax bill associated with the stock sale. If the options lose money, those losses can be used to offset the tax bill resulting from an unwinding sale of the underlying security. Proper execution of this strategy should allow for an investor to liquidate a position over 3-7 years without having to fund additional tax payments.
Source: Simon Quick Third Party Manager Research
Pros: Transfer of single name risk into market risk, receive back a diversified basket of holdings after 7 years
Cons: No tax benefits or improvement in cost-basis, moderately illiquid
Exchange funds are special investment vehicles that allow for investors to contribute appreciated stock holdings into a large, diversified pool of other stocks in exchange for a proportional interest in that pool. After the contribution of owned shares to the fund, the tax basis will not change, but risk is immediately diversified. The two primary benefits of this type of investment solution are risk reduction through diversification and deferral of tax payments. After an investment is held within an exchange fund for 7 years, the investor becomes eligible to redeem a basket of shares from the fund rather than only the stock that was contributed. These baskets usually consist of about 10-30 names and are diversified by sector and distributed in-kind to investors. Like the contribution, the redemption is not a taxable event, however it is worth noting that through this strategy you are merely deferring the payment of taxes, not eliminating them. The redeemed stocks will maintain a basis similar to that from when the concentrated stock which was originally contributed. In many situations investors have also found exchange funds to be great estate planning tools as a step-up in basis will occur upon death.
Ultimately deciding on which of the aforementioned solutions is most appropriate should be done on a case by case basis, and within the context of an investor’s total portfolio. Investors could also benefit from a combination of these solutions, particularly when managing for future liquidity needs. For those who may have found that their “conviction” stock position has become too concentrated, we welcome the opportunity to discuss the various options available to you in further detail.
Would you like to speak further about stocks and your options? We would love to chat!
- Bloomberg, 2/27/2019-10/31/2019
- Divide and Prosper: Preserving Wealth from Single-Stock Positions, Goldman Sachs
- Frequently Asked Questions on Gift Taxes.” Internal Revenue Service, www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-gift-taxes.
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