By Nick Maggiulli, originally published at Of Dollars And Data.
I recently joined a professional organization to discuss various topics in wealth management. On our first Zoom call there was a debate around the use of levered long/short strategies. For the uninitiated, a levered long/short strategy is a way of taking market risk (like buying an index fund) while generating tax losses to offset capital gains (now or in the future).
The leverage is what’s important here. By borrowing against your holdings, you can short some securities while keeping the same overall market exposure as an index fund.
So if the market goes up, you’d close your short positions (which lost money) to generate tax losses and hold your long positions (which made money). And if the market goes down, you do the opposite.
Depending on how the market performs and how much leverage you use, you can generate cumulative net capital losses ranging from roughly 30% to 200% of the original capital invested over a decade. So if you invested $1M, these strategies could create anywhere from $300,000 to $2M in losses. These losses can then be used to reduce your current (or future) tax bill.
The long/short strategy has grown in popularity in recent years and some custodians are worried about the risks. As a result, Schwab recently raised the minimum to $10M on some of these accounts (up from $1M), while Fidelity has indefinitely paused onboarding new clients into the strategy.
While the financial benefits of a long/short strategy are clear, the psychological costs are often overlooked. Because while this strategy generates large tax losses, it also generates large unrealized gains. And these gains can keep you trapped in your positions for life. Let’s look at a simplified example to see why.
Imagine two stocks (A and B) with identical returns and prices, but from different companies. You own one share of stock A that is currently $100/share. Assume stock A falls to $80 a share and you sell it to generate a $20 capital loss. You then use the proceeds from that sale ($80) to buy one share of stock B (which is now also $80 a share). If stock B ends up recovering to $100 a share, what do you have?
You have a $20 capital loss on stock A ($100 -> $80) and a $20 unrealized gain on stock B ($80 -> $100). Is this beneficial to you? Yes, especially if your current tax rate is higher than your expected future tax rate. Why? Because that $20 capital loss (from stock A) will reduce your current tax bill by a larger amount than what you will pay on your $20 unrealized gain (from stock B) in the future.
For example, imagine your tax rate today is 35% and your tax rate in the future is 20%. The $20 capital loss saves you $7 today (35% of $20) yet would only cost you $4 in the future (20% of $20). So you save $3 on taxes without factoring in the time value of money.
But do you know how most investors typically use this strategy? They never sell stock B (with the unrealized gains). They take it to their grave instead. Why? Because of the stepped-up basis rule. This rule states that, upon your death, all of your assets have their basis “stepped-up” to their current market value. It’s as if you bought those assets on the day of your death before transferring them to your heirs.
In other words, it’s like having a future tax rate of 0%. Using our prior example, the $3 in tax savings ($7 – $4) would now be $7 in tax savings ($7 – $0). You save $7 today (35% of $20) from stock A and pay no taxes in the future on stock B (0% of $20) when you die.
Once again, this is great financially, but think about what this strategy does to you psychologically. As it generates more gains, it lowers your likelihood of ever selling these positions. Why? Because, in my experience, people hate paying taxes more than they like making money. As a result, you can end up stuck in the strategy.
This is by design. A levered long/short strategy generates lots of losses in the early years, but as markets (typically) drift upward over time, there are fewer and fewer losses to harvest. As a result, you end up with an increasing amount of unrealized gains.
Now you might be thinking, “But Nick, isn’t this true of any portfolio? Won’t my index fund be sitting on lots of unrealized gains in 30 years too?” Yes, but there’s a difference between gradually accumulating unrealized gains over a lifetime and manufacturing them on purpose decades earlier. Unfortunately, gains generated that quickly can become a financial prison that you can’t escape from.
Some of you may argue that this is the point of the strategy after all. But think about the tradeoff associated with it. You get some modest tax savings now (which higher fees and financing costs partially offset), but you have to lock up a huge chunk of your capital until death.
What’s the point of working so hard to save that money in the first place if you’re just going to pass it to your children in their 50s? A lot of retirees are in this exact scenario. Instead of paying some tax and enjoying more of their money now, they hold onto it for someone else to enjoy later.
It’s giving up current consumption to give up future consumption. It’s living poor to die rich. I don’t mean poor financially. People sitting on lots of unrealized gains are undeniably wealthy. I mean poor in the sense that money you’ll never spend isn’t really your money.
I get it—taxes suck. But you can’t let them run your life. And yet, for some people, they do. Isn’t it odd though?
Work hard.
Sacrifice.
Save.
Invest.
Watch it grow.
And then…don’t touch it?
Huh??
I get that providing money to heirs is important. But at what cost? Is giving your children $1M when they’re 50 better than giving them $250,000 when they’re 30? I don’t think so, and most people seem to agree. Of course, we don’t all need to Die with Zero, but this idea seems more directionally accurate than what most retirees are currently doing.
Yes, there are scenarios where deferring taxes until death can make perfect sense. For example, you have a large concentrated position that you need to exit and you want to offset the gains while doing so. I’m not against these targeted approaches.
However, it’s hard to reverse course once you get going. As a result, you could end up not using your money as you originally intended. That’s the fate I want all investors to avoid.
You don’t have to be in a levered long/short strategy to succumb to this either. Anyone can feel trapped by their gains, especially after a long bull market. The difference is timing. An index fund may trap you at 70, but the levered long/short strategy could do it by 50, with many decades of spending still ahead of you.
But it doesn’t have to be this way. Because it’s your money and you should feel free to spend it. That’s what the money is for after all.
So, you can live poor and die rich, or live rich and die a bit less rich. The choice is yours.
Thank you for reading.
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This is post 519. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data
Nick Maggiulli writes at Of Dollars And Data. Read this article on their site.
