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Blog > Tax Planning for Hedge Funds and Individuals

Tax Planning for Hedge Funds and Individuals

As any investor knows, it’s not what you make but what you keep.

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“In this world, nothing is certain except death and taxes.”

It’s up for debate who actually coined the phrase (Ben Franklin, Mark Twain, and English actor and dramatist Christopher Bullock lead the list), but we have all heard this pessimistic quotation. However, there is a silver lining: While paying taxes is still inevitable, strategic tax management can help reduce the burden. A tax-loss harvesting strategy may help an investment manager or individual investor keep more of what they earn. Find out how it all works and why we think it is a worthwhile strategy for hedge fund managers and individuals to consider not only at year-end but also throughout the year.

The stock and crypto markets are both down significantly since the beginning of 2022. Funds and other investors may have considerable realized and unrealized losses, so effective tax planning ahead of year-end may help soften the overall economic impact. In this article, we focus on one key technique and the pitfalls to avoid with the strategy known as tax-loss harvesting. Simply put, tax-loss harvesting is a strategy designed to reduce the overall tax bill so a U.S. investor can keep more of what is earned on their investments. Under current U.S. federal tax law, it’s possible to offset your capital gains with capital losses you’ve incurred during that tax year or carried over from a prior tax return. Capital gains are generally the profits you realize when you sell an investment for more than you paid for it, and capital losses are generally the losses you realize when you sell an investment for less than you paid for it.

In summary, tax-loss harvesting is done by selling investments that are losing money, (and thus turning an unrealized loss into a realized loss) and using that capital loss to reduce taxable capital gains. Further, in the event capital losses exceed taxable capital gains each year, excess capital losses may also be used to offset up to $3,000 per year of ordinary income.

Let’s say an investment manager earns a profit for its limited partners of $30,000 by selling Stock A. Meanwhile, they notice that Stock B is down by $15,000. By selling Stock B, they can use those capital losses to partially offset the capital gains from Stock A — meaning the fund would only pass on $15,000 of taxable capital gains instead of $30,000 to its limited partners. “Harvesting” that $15,000 loss, in this case, would have no effect on the portfolio’s overall value, and they could use the proceeds to buy a similar investment. That would allow the manager to maintain roughly the same asset allocation while reducing the federal income taxes passed on to the limited partner, leaving the investor with additional funds that would remain in the investment portfolio continuing to earn investment gains.

When repeated in a systematic way, year in and year out, tax-loss harvesting can reduce the portfolio’s tax bill. That means an investor is not only saving money on their taxes in a given year, but they can reinvest those tax savings for potential growth in the future. And the longer a portfolio stays invested, the more time it has to grow and compound. Not all stocks perform the way they are intended, leaving investors with the option to realize capital losses to offset any capital gains.

Although tax loss harvesting can indeed be an effective strategy, there are some important considerations to ensure you maximize the benefits of what you are selling and how you then redeploy the capital. Certainly, you should always check with your tax advisor to ensure that your desired outcome is executed properly given the nature of your portfolio and ever-changing tax laws.

There are two things, in particular, to consider (seek professional advice as needed).

Wash Sales

You’ll want to make sure you don’t inadvertently trigger a “wash sale,” which occurs when you sell or trade stock or securities at a loss and buy substantially identical stock or securities within 30 days before, or 30 days after, the sale. This rule is in place to prevent people from gaming the system. Basically, it says that you can’t sell Security B and then immediately buy it back again just to get the tax benefit. Should you do so, the capital loss will immediately be deferred. You are, however, allowed to claim the loss currently if you sell one stock and buy another one in the same industry — just not stock in the same exact company as before, or another investment that the Internal Revenue Service (IRS) would consider “substantially identical” to that which was sold. One way to avoid a wash sale on an individual stock, while still investing in the industry of the stock you sold at a loss, would be to consider substituting a mutual fund or an exchange-traded fund (ETF) that targets the same industry. The “substantially identical security” rule can be a highly technical matter so it’s best to work with an investment or tax advisor to better understand how that may apply. There are also different wash sales strategies that utilize options which can be a relevant part of an investment manager’s loss harvesting planning in certain scenarios when an investment manager doesn’t want to lose exposure to a specific security in their portfolio, but are sophisticated strategies that carry more economic risk and should only be considered in consultation with specialized tax advisors.

  • One interesting note on the Wash Sale Rule is that the IRS currently defines cryptocurrency assets as property, not securities. Therefore, the wash rule doesn’t technically yet apply to digital assets. Many crypto investors take advantage of this loophole with crypto tax loss harvesting, or strategically selling assets at a loss in order to lower their tax bill. However, the regulatory landscape for crypto is always changing and you should be sure to seek professional counsel and advice.

Short-Term Versus Long-Term Gains and Losses

The government incentivizes people to invest for the long term rather than constantly buying and selling on fleeting news. It does so by taxing short-term capital gains (profits made from selling investments held for a year or less) at a higher rate than long-term capital gains (profits from investments held longer than a year). So, to the extent possible, it can have a particularly high impact on your tax bill to offset short-term investment gains with losses. In other words, tax-loss harvesting can make a bigger difference if you trade a lot or have invested in strategies that see higher turnover and thus more short-term gains. Note that certain rules in the Internal Revenue Code dictate whether particular capital losses offset short- versus long-term capital gains. If you are not sure, you should consult a tax advisor.

The Bottom Line

While market returns vary from year to year, volatility is a constant. Volatility and dispersion of investment returns create potential opportunities to harvest losses which can add value to an investment portfolio through higher after-tax returns for U.S. investors. Of course, the amount of potential tax savings depends on several factors. Our experienced team of Arootah consultants has hands-on expertise in strategies for both hedge funds and individual accounts and can add tremendous value to the planning and execution of tax loss harvesting strategies and other tax planning tools. We focus on outperforming on an after-tax basis by using active tax-management techniques.

As any investor knows, it’s not what you make but what you keep. And that’s certain.

Steven Wilner is Arootah’s chief operating officer, overseeing the company’s daily business operations, leading key initiatives, and implementing company-wide strategies. Steven has more than 34 years of industry experience as a COO, CFO, and CCO in building, growing, and leading successful hedge fund, investment advisory, and asset management firms across a wide variety of strategies. His hands-on experience with all aspects of the business, financial, and operational needs of hedge funds, family offices, and investment management firms has enabled him to successfully consult and advise several start-ups and established firms on best practices, process improvement, business development, and organizational efficiencies that have resulted in significant and measurable growth and cost-saving measures.    

Disclaimer: This article is for general informational purposes only and does not constitute legal, investment, financial, accounting, or tax advice, or establish an attorney-client relationship.  Arootah does not warrant or guarantee the accuracy, reliability, completeness, or suitability of its content for a particular purpose. Please do not act or refrain from acting based on anything you read in our newsletter, blog, or anywhere else on our website. 

Disclaimer: This article is for general informational purposes only and is not intended to be and should not be taken as professional medical, psychological, legal, investment, financial, accounting, or tax advice. Arootah does not warrant or guarantee the accuracy, reliability, completeness, or suitability of its content for a particular purpose. Please do not act or refrain from acting based on anything you read in our newsletter, blog or anywhere else on our website.

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