Tax-aware investing strategies: Clearing the hurdles

Editor: Jessica L. Jeane, J.D.

“How can an investment lose money yet still make money?” was my first thought after meeting with a wealth adviser colleague to discuss tax–advantaged investments. These were investments designed to generate capital losses yet still deliver a positive investment return. It seemed far–fetched — my CPA brain was skeptical. Despite my best efforts to poke a hole in the strategy, however, I could not do so.

What this wealth adviser was pitching was not a brand–new idea. The strategy, direct indexing, emerged in the 1990s as a way for affluent investors to own the individual securities of an index fund directly, thus enabling efficient harvesting of tax losses. What is new is that technology has expanded access to such strategies. As tax–aware investing goes mainstream, CPAs need to understand the benefits as well as the risks.

How can the strategy both win and lose?

First and foremost, CPAs need to understand that a portfolio does not have to lose money overall for the client to realize capital losses.

In a traditional exchange–traded fund (ETF) or mutual fund, the client owns a share of a large basket of companies, the value of which fluctuates based on the underlying shares. If the fund itself realizes losses, those losses do not flow through to the fund’s owner.

Conversely, in a direct indexing account, the client owns a basket of individual securities designed to track a benchmark index (e.g., the S&P 500). Within this basket, some securities’ value may go up and some down. Those that are down can be sold to realize losses for the direct investor, and then similar but not substantially identical securities may be purchased to maintain the benchmark market exposure. For example, the financial adviser sells Coca–Cola Co. stock at a loss and uses the proceeds to purchase PepsiCo stock. This ability to harvest specific security losses, even when the overall portfolio is net positive, is one of the key tax advantages of direct indexing.

A long–short direct indexing strategy takes the concept a step further. Instead of a portfolio being limited to a 100% long–only position (i.e., with the expectation that shares will increase in price), managers make use of leverage and short selling (i.e., selling borrowed shares that can be redeemed with less–expensive shares). An example is a 130/30 strategy, where 130% of the portfolio is long and 30% is short but the overall net equity exposure remains 100%. The short position will lose money when the securities rise in value, and that loss is realized when the short sale is closed.

What does the Internal Revenue Code (IRC) say about this strategy?

The challenge for investment managers is that several IRC sections seek to limit these losses. Much as how a hurdler with great footwork and timing soars over the hurdles, proper diligence and structure can make the loss–realization hurdles almost seem to disappear. Five of the most common loss–limiting provisions are:

Hurdle 1. Sec. 1091, the wash-sale rule: In general, 30 days before the sale date and 30 days after that date is a no-go zone for purchase of a replacement security that is substantially identical to the security that generated the loss. If a substantially identical security is purchased, then the loss on the disposition is not currently deductible; rather, it is added to the basis of the replacement securities. This IRC section also applies to contracts or options to acquire or sell stock or securities. This is why, in the direct indexing world, similar but not substantially identical securities, as mentioned above, are purchased in substitution of the security that just realized the loss, e.g., PepsiCo for Coca-Cola Co. The direct indexing strategy of betting on the benchmark, not the individual stock, is in the mindset of mitigating the wash-sale rules.

CPAs should make sure the manager of these direct indexing or tax–aware long–short strategies consider all of a client’s brokerage activity. This includes other brokerage accounts, employer stock plans, option activities, trust accounts, IRAs, and Roth IRAs. A taxpayer who sold Coca–Cola Co. stock at a loss in their taxable brokerage account but then repurchased Coca–Cola Co. through their IRA within the 61–day testing window does not avoid the wash–sale rule.

While Sec. 1091 is unfavorable, it is usually not fatal. As mentioned, the disallowed loss is added to the basis of the replacement security and can be deducted when that asset is disposed of in the future. Note, however, that under Rev. Rul. 2008–5, where a taxpayer sells stock or securities for a loss and purchases substantially identical stock in a traditional or Roth IRA, not only is a wash–sale loss disallowed, but the basis in the IRA or Roth IRA is not adjusted; thus, the loss is effectively never allowed.

To clear Hurdle 1, the tax adviser should ask: Do the losses survive Sec. 1091 across the taxpayer’s entire range of accounts?

Hurdle 2. Sec. 1092, the straddle rule: Sec. 1092 prevents taxpayers from recognizing the portion of a loss in one or more positions that does not exceed the unrecognized gain in one or more offsetting positions. This limitation applies to positions in actively traded personal property, including futures contracts, forward contracts, and options, where the taxpayer’s risk of loss from one position is substantially diminished by another position. Losses not in excess of the unrecognized gain in the offsetting position are not currently allowed and are treated as sustained in the succeeding tax year, potentially subject to the same limitation.

For tax–aware long–short strategies such as 130/30 mentioned earlier, Sec. 1092 must be considered. Not every long–short portfolio creates a straddle issue, but it applies when positions are designed to offset one another inside the strategy. For example, if the portfolio incurs a $10,000 loss on a short option position but continues to hold an offsetting long position in substantially similar or related property that has $15,000 of unrealized gain, the $10,000 loss is deferred.

To clear Hurdle 2, the tax adviser should ask: Were any of the harvested losses part of an offsetting position, and, if so, did Sec. 1092 defer any portion of the loss?

Hurdle 3. Sec. 1233, short sales: Long–short strategies require tax advisers to understand short sales. As mentioned earlier, a short sale occurs when the taxpayer sells a borrowed security and delivers it to the buyer. To close the short position, the taxpayer buys the same or a substantially similar security and returns it to the lender. Generally, a short seller is betting on a decrease in the security’s value.

For tax purposes, a gain or loss generally is not realized when the short sale is initiated; rather, it is realized when the entire transaction is closed. Sec. 1233 determines the character of gain or loss from the short sale. Gain or loss from a short sale is capital gain or loss if the property used to close the short sale is a capital asset in the taxpayer’s hands, e.g., securities.

But the short–sale character rules can seem backward if the investor does not pay close attention. If a taxpayer holds substantially identical property for one year or less or acquires substantially identical property during the open short–sale period, gain on the short sale is treated as short–term capital gain, which logically tracks. But on the loss side, if the taxpayer held substantially identical property for more than one year on the date the short sale opened, the loss on closing the short sale may be treated as a long–term capital loss, even if the property used to close the short sale was held for one year or less.

Typically, in these tax–aware long–short strategies, the investment manager and taxpayer want to generate short–term capital losses. Thus, a short sale characterized as a long–term loss may not produce the desired outcome.

Much like the wash–sale rule, Sec. 1233 requires the tax adviser to look beyond the single brokerage account where the short sale occurred. Sec. 1233 specifically looks at whether the taxpayer held or acquired substantially identical property. For individuals, the statute also includes spouses in the definition of “taxpayer” (Sec. 1233(e)(2)(C)). Accordingly, the tax adviser should evaluate substantially identical positions held by the client or spouse across other brokerage accounts, employer stock plans, and any coordinated investment accounts — not just the manager’s account–level report.

To clear Hurdle 3, the tax adviser should ask: Are the realized short sale losses properly characterized as short– or long–term and separately reported with enough detail to prepare the return?

Hurdle 4. Sec. 1256, mark–to–market and 60/40 treatment: This is another but different kind of hurdle for the direct indexing strategy to clear. While it may not apply to every type of direct indexing or tax–aware long–short strategy, it is important to identify whether the manager is using Sec. 1256 contracts, such as regulated futures contracts, certain foreign currency contracts, nonequity options, dealer equity options, or dealer securities futures contracts.

The basic rule of Sec. 1256 is mark–to–market treatment. If the taxpayer holds a Sec. 1256 contract at year–end, the contract is generally treated as sold as of the last business day of the year at its fair market value (FMV). Gain or loss is recognized even though the position may not have been closed. The treatment of this gain follows the 60/40 rule, where 60% of the gain or loss is long–term and 40% is short–term.

If a taxpayer’s goal is to increase short–term loss production, Sec. 1256 treatment can frustrate that plan. But if the goal is to generate losses of any character, then the 60/40 split under Sec. 1256 might not matter. While this rule may not apply to a direct indexing or tax–aware long–short strategy, it is important to understand.

To clear Hurdle 4, the tax adviser should ask whether the strategy used Sec. 1256 contracts and, if so, how much of the resulting gain or loss falls into 60% long–term and 40% short–term buckets.

Hurdle 5. Sec. 1259, the constructive–sale trap: When tax–aware strategies are used as partof a plan to manage an appreciated concentrated stock position, the tax adviser should consider the constructive–sale rules under Sec. 1259.

Generally, Sec. 1259 provides that if a taxpayer holds an appreciated financial position and enters into certain offsetting transactions, the taxpayer may be treated as having sold the appreciated position for its FMV. This can lead to gain recognition without an actual sale. The statute applies where a taxpayer or a related person enters transactions such as a short sale of the same or substantially identical property, an offsetting notional principal contract with respect to the same or substantially identical property, or a futures or forward contract to deliver the same or substantially identical property (Sec. 1259(c)(1)).

Assume a client owns a large, low–basis position in a publicly traded company they founded. While the client is not ready to sell, they want to reduce the risk of holding such a concentrated position. A long–short overlay may be presented as a way to reduce volatility and diversify the position. If a hedge is too direct, then the IRS may deem the client as having made a constructive sale under Sec. 1259, thus causing a cashless taxable gain.

To clear Hurdle 5, the tax adviser should ask whether the strategy is hedging an appreciated position and whether that could trigger constructive–sale treatment.

When these loss-harvesting strategies may fit

The most obvious case for a tax–aware strategy is a client anticipating a large capital gain, such as a sale of a business, a sale of investment real estate, a private–equity liquidation, or other liquidity event. In those instances, the tax adviser needs to know the character of the expected gain. While capital loss harvesting can offset capital gains from a liquidity event, it generally will not offset ordinary income, depreciation recapture, compensation income, or other noncapital income.

Tax–aware investing can also complement other deferral strategies. With the permanency of opportunity zone funds following the enactment of H.R. 1, P.L. 119–21, commonly referred to as OBBBA, taxpayers have clarity around how these funds will work prospectively. For investments of eligible gains made in funds after Dec. 31, 2026, taxpayers can generally elect to defer recognition of the gain until the earlier of an inclusion event or five years after the qualifying investment is made, at which time the deferred gain is included in income. A capital–loss–harvesting strategy can mitigate or eliminate the resulting tax bill.

Installment sales are another planning area. If a sale qualifies for installment sale reporting, the seller generally reports gain as payments are received. With installment sale reporting, the taxpayer often has a good idea of when gains will be recognized. Losses from tax–aware investing can be timed to offset capital gain recognized on future installment payments, further reducing the overall tax bill.

The same concept applies to Sec. 1031 exchanges. A properly structured like–kind exchange defers recognition of gain on real property held for productive use in a trade or business or investment, but boot received or a failed exchange may create taxable gain. A tax–aware loss strategy can help hedge against gain recognition, but the loss plan should not be built on a transaction that may never produce taxable gain.

Qualified small business stock (QSBS) is another use case, especially after H.R. 1. For QSBS acquired after July 4, 2025, the gain exclusion is 50% after three years, 75% after four years, and 100% after five years. That means a founder or investor who exits before the full five–year holding period may recognize taxable gain on a portion of the transaction. Harvested capital losses can help offset that taxable gain. But if the gain is fully excluded, the losses will not be needed. The value is in modeling the actual tax result, not admiring the strategy in the abstract.

A final word of caution

So, can an investment lose money and make money at the same time?

Yes, but only if it is built precisely around harvesting losses while staying invested in the overall long strategy. That is the economic answer, but the tax answer can be harder because those losses must clear the hurdles in the IRC.

At that meeting three years ago, I could not find the obvious hole in the strategy. After reviewing the tax rules, I do not think the hole is in the strategy itself; rather, the issue arises when the strategy is promoted as a magic capital loss generator. Without understanding the potential tax pitfalls, there can be unforeseen repercussions.

Tax–aware long–short strategies can create real after–tax value, but only when they are properly implemented. That is where the tax adviser earns a seat at the table: not by rejecting the seemingly miraculous result outright and not by accepting the marketing presentation at face value but by asking whether the tax losses survive long enough to matter in the end.

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Editor

Jessica L. Jeane, J.D., is director of tax policy, national tax, with Baker Tilly in McLean, Va.

For additional information about these items, contact Jeane at Jessica.Jeane@bakertilly.com.

Contributors are members of or associated with Baker Tilly.

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