Implementation of Tax Optimization Techniques

The following are several important topics for tax-aware portfolio management, each summarized in greater detail below:

• Selection of the investment vehicle (i.e., whether the assets are held in a partnership, fund, or separate account).
• Tax lot accounting.
• Tax-loss harvesting.
• Tax deferral.
• Quantitative tax management.

Investment Vehicle

The choice of investment vehicles includes commingled funds such as mutual funds, UCITS, and partnerships. Clients may also directly own investments managed through a separately managed account (SMA).

Whether it is a hedge fund or a private equity fund, taxes are typically passed through to the underlying partners. A partnership is an attractive tax structure since the fund itself operates tax-free, while distributions are typically treated as capital gains and not as ordinary income.

Investors can determine whether a holding has a significant capital gain embedded in it by calculating metrics like Potential Capital Gain Exposure (PCGE). PCGE measures how much an asset has appreciated by estimating the percentage of assets that represent gains. It can indicate future capital gain distributions.

\(\text{PCGE} =\frac {\text{net gains (losses) }}{\text{ total net assets.}} \)

There are some commingled structures that are more tax-efficient than others. When shares are created and redeemed for ETFs, for example, low-cost-basis holdings can be provided to trading partners, so that any embedded capital gains tax liability can be reduced. Unlike mutual funds, ETFs aren't sold directly to investors and help deliver a more tax-efficient investment strategy.

Separately-managed accounts (SMAs) offer the most flexibility. A capital loss in an SMA can be used outside of the SMA, in clients' other holdings. A mutual fund does not offer this same flexibility, as only other gains in the same fund can be offset by the same fund's losses.

• Partnership: Tax liabilities are shared by the partners.

• Mutual fund: Tax liabilities are affected by other holders in the fund. They may decide to sell shares, and trigger capital gains tax for all other holders.
• Exchange-traded fund (ETF): Tax liabilities can be reduced or eliminated through the creation and redemption process.
• Separate Managed Account: Realized gains and losses can be combined across all of the client's accounts.

Tax Loss Harvesting

Tax-loss harvesting refers to a situation in which a trader has accumulated capital gains in a portfolio. They may then sell a position with an unrealized capital loss to offset the gain. In many jurisdictions, this is allowable and can lead to higher after-tax wealth accumulation. Tax-loss harvesting does not reduce the overall tax bill of the investor, as taxes on gains must be paid eventually. What it does accomplish is delaying the payment of gains, which has a time value of money benefit.

Another subtle benefit is that tax-loss harvesting increases available capital for trades by liquidating positions. This increases the amount of net-of-tax money available for new trades.

Tax Lot Accounting

HIFO refers to a situation in which investors have made multiple purchases over time, and have accumulated positions with various cost-bases. When the positions are finally sold, the investor is not always required to sell the most recently purchased, or oldest security within the tax lot. Often HIFO is allowed.

HIFO means selling positions that have the highest cost-basis first and leaving positions with a lower cost-basis in the account. This has the effect, not of getting rid of taxes, but of delaying the payment of taxes that are eventually owed. This can carry a substantial time-value of money benefit. (Think of paying future obligations later, rather than sooner, when their relative purchasing power will be less).

One important caveat is that investors who expect to be in higher tax brackets in the future should not use this technique. This could be due to changes in tax laws, or large changes in income. If an investor expects to receive light tax treatment now as compared to the future, it is likely advisable to use the opposite of HIFO, which is LIFO.

Quantitative Tax Management

Quantifying and managing the risks associated with portfolio implementation is a fundamental aspect of tax management. The tracking error is one common metric of risk compared to a benchmark. Quantitative tax management involves estimating the correlations and risks of each security in a portfolio using a quantitative risk model. The risk estimates from the model are then used as inputs to a portfolio optimization algorithm that:

• Minimizes tracking error risk versus the index or model portfolio.
• Maximizes realized losses.
• Minimizes realized gains.
• Minimizes trading costs.
• Satisfies any investor constraints. 

Question

Which of the following is not a benefit of tax-loss harvesting?

1. Reduction in the tax bill.
2. Frees up capital for other opportunities.
3. Delays payment of capital gains.

Solution

The correct answer is C.

This is not a benefit of tax-loss harvesting. In fact, tax-loss harvesting typically involves selling investments that have experienced losses to offset capital gains, which could result in a tax benefit in the current tax year. However, it doesn't necessarily delay the payment of capital gains taxes; it aims to reduce or eliminate them by offsetting gains with losses.

A is incorrect. Tax-loss harvesting can indeed lead to a reduction in the tax bill by offsetting capital gains, thereby reducing the overall taxable income and the associated tax liability.

B is incorrect. Tax-loss harvesting can provide liquidity by freeing up capital that was tied up in losing investments, allowing it to be reinvested in potentially more promising opportunities.

Reading 8: Topics in Private Wealth Management

Los 8 (f) Discuss risk and tax objectives in managing concentrated single-asset positions