Tax Efficient Strategies to Diversify Concentrated or Highly Appreciated Holdings
Although the most straightforward and streamlined approach to diversifying away from concentrated stock is to sell the position and reinvest the proceeds, it may not always be the most appropriate or practical solution. We have detailed two different tax-advantaged strategies below to create portfolio diversification without the need to sell the security upfront.
Lending & Tax Managed Separately Managed Accounts (SMAs)
Investors who hold concentrated stock positions that want to reduce portfolio risk, while remaining tax efficient, may want to consider margin lending and investing those proceeds in a tax managed separately managed account (SMA). Borrowing on margin means taking an interest-bearing loan and using the securities you own in your brokerage account as collateral. The amount of margin available will depend on the type of security, but typically margin loans can be 50-70% of a security’s market value. For example, if an investor owns $1,000,000 position in Apple stock, they may be able to borrow upwards of $700,000 that can then be used to buy other investments that further diversify the portfolio. Margin loans can provide many benefits such as readily accessible liquidity, relatively low interest rates, and potential tax advantages as the loan interest may be tax deductible. Before using margin loans, investors should be aware of the risks as well. It is important to understand the maintenance requirement when borrowing on margin. The maintenance requirement is the minimum level of equity that is required by a brokerage firm. If the equity value falls below the maintenance requirement, investors may be forced to sell securities at depressed levels, potentially locking in losses. The use of margin does not mitigate the risk of loss in the portfolio. In order to protect against a potential margin call, investors should consider purchasing put options on the concentrated security to help offset depreciation in the security’s share price. Additionally, the cost of the interest expense and put hedges should be considered in the overall analysis.
If an investor decides a margin loan is a viable diversification strategy, they may want to consider investing the proceeds in a tax managed SMA. Tax managed strategies employ a quantitative approach to index investing with a focus on tax loss harvesting. Tax loss harvesting is the process of selling certain investments within a basket of securities at a loss, while simultaneously replacing them with different investments that exhibit similar characteristics. This process enables the strategy to generate losses that can be used to offset any capital gains but maintain a close correlation to the selected underlying index, unaffecting an investors desired exposure. Realized losses in the tax managed portfolio will allow an investor to sell portions of the concentrated stock over time while minimizing the tax burden and reducing the concentration risk. If the investor was to continue reinvesting the proceeds from the concentrated stock into the tax managed portfolio, they would essentially create a “basis shift” from the concentrated stock to a diversified portfolio. In turn, the diversified portfolio would leave the investor in a much better position from a risk perspective.
For individuals who are charitably inclined, donations of concentrated stock can be made directly to a charity and or charitable gift fund for simplicity, but a Charitable Remainder Trust may be another effective strategy to help improve diversification and reduce concentration risk, while also accomplishing philanthropic and lifestyle goals. A Charitable Remainder Trust is an irrevocable “split interest” trust designed to provide financial support to an income beneficiary for a period of time, while the remainder interest is passed on to a designated charitable beneficiary. There are two types of charitable remainder trusts:
- Charitable remainder unitrust (CRUT)
- Charitable remainder annuity trust (CRAT)
A charitable remainder unitrust is designed to distribute a fixed percentage to the income beneficiary based on its year-end balance, whereas a charitable remainder annuity trust distributes a fixed dollar amount to the income beneficiary each year.
A charitable remainder trust works in the following way. First, the grantor, the person establishing the trust, contributes assets to fund the trust which is set up to operate during a specific term or measuring life. Typically, it is best to fund the contribution with highly appreciated assets as sales inside the charitable remainder trust are not subject to capital gains taxes. Once the trust is established and funded, payments from the trust are disbursed to the income beneficiary, which can be the grantor or another designated individual, as either a fixed percentage or fixed dollar amount. Lastly, at the end of the term, the remainder assets are distributed to one or more charitable beneficiaries.
Charitable Remainder Trusts (CRT) offer many key benefits.
- Preserve the value of highly appreciated assets – Assets donated to a charitable remainder trust are exempt from capital gains taxes. By donating assets in-kind to the CRT, you will preserve the full fair market value of the assets rather than reduce it by large capital gains taxes, allowing more money for the income and charitable beneficiaries.
- Upfront income tax deduction – With a CRT, you have the potential to take a partial income tax charitable deduction when you fund the trust, which is based on a calculation on the remainder distribution to the charitable beneficiary.
- Tax exempt – This makes the CRT a good option for asset diversification. You may consider donating low-basis assets to the trust so that when sold, no income tax is generated to you, and you eliminate the capital gains tax on the sale of the asset. However, the named income beneficiary will pay income tax on the income stream received. With a CRT, the donor must pay tax on the income stream, which is categorized into four tiers: (1) Ordinary income and qualified dividends, (2) capital gains, (3) other tax-exempt income; and (4) return of principal. Only when a higher tier of income is exhausted does the next tier apply.
- Generates an income stream – Trust income can be paid to you for your lifetime. If you are married, it can be paid for as long as either of you lives. The income can also be paid to your children for their lifetimes or to any other person or entity you wish, providing the trust meets certain requirements. Just remember, however, that the longer the term of the trust, the smaller the value of the upfront income tax deduction.
Conclusion: Plan with an Advisor
With the rise in equity volatility this year, the detrimental effects of concentrated stock positions have become a widespread reality for many investors and serves as a reminder of the power of diversification. More importantly, the current market environment should act as a trigger to consider how to transition towards a more diversified asset allocation. At Round Table Wealth Management, we encourage all concentrated investors to develop a formal, predetermined plan for their concentrated positions to help take the emotion out of the decision to sell. Working with a professional advisor allows for an objective, unbiased perspective and the creation and execution of a plan that works in coordination with your overarching financial goals and objectives.
Please contact us to learn more or to speak to a wealth advisor to discuss your specific situation.
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