I recently defended tax-loss harvesting against its critics. But there was a twist. I noted that while tax-loss harvesting is truly valuable, it is not the star of tax management. That honor belongs to gains deferral. This is a bit shocking for many folks, like learning that Sherlock Holmes has a smarter older brother (Mycroft Holmes). Loss harvesting gets the attention; gains deferral does most of the work. We thought we’d do our bit to bring gains deferral out of the shadows and give it the acclaim it deserves.
What is gains deferral?
Gains deferral is the act of holding a position that, but for tax considerations, you would otherwise sell. There are two types:
• Short-Term Gains Deferral: You delay selling a short-term position until it’s long term. Roughly speaking, this cuts your tax bill in half.
• Long-Term Gains Deferral: You delay selling a long-term position, maybe for just a while, maybe indefinitely. If you sell eventually, you’re still getting value in the form of a delayed (deferred) tax bill. It’s the equivalent of an interest-free loan. And if you never sell, either because you hold the position until death or you donate the position to charity, you avoid capital gains taxes entirely.
Why is gains deferral more valuable than loss harvesting?
One of the criticisms of loss harvesting is that, on average, markets and investment portfolios go up in value, so eventually you have no more loss harvesting opportunities. We’ve explained why this isn’t quite true. (There’s always stuff happening, like rebalancing and cash flows, that can create new loss harvesting opportunities.)
But it’s not completely false either. In a portfolio that is properly managed for taxes, you will get lots of appreciated securities. That’s bad for loss harvesting, but good for gains deferral. After a few years, gains deferral becomes the dominant tax management strategy.
We can quantify this. Smartleaf generates a Taxes Saved Report for every account managed in our system that breaks down taxes saved from loss harvesting and gains deferral. In 2018, 78% of taxes saved came from gains deferral versus 22% from loss harvesting.
Why is gains deferral hard?
Gains deferral sounds simple. After all, how hard is it to not sell something? But there’s more going on than just refraining from a sale. The challenge of gains deferral is to avoid selling appreciated positions while still ending up with the portfolio you want. The downside of holding onto a position for tax reasons is that you’re left owning more of the position than you want. And that means you're exposed to a particular stock’s performance more than you want to be. The key to competent gains deferral is keeping this risk under control.
How? First, actively “counterbalance” overweighted positions by underweighting securities that are most correlated with the security that is overweighted. If you’re overweighted in Exxon, underweight Chevron. The idea is to keep core “characteristics” (e.g. beta, capitalization, p/e, sector, industry, momentum etc.) of the portfolio unchanged.
Second, don’t overdo it in the first place. If an appreciated security constitutes the majority of a portfolio, a deferral of all gains would be a case of the proverbial tax tail wagging the investment dog. How much is too much? It depends on 1) How volatile the security is, 2) Your return expectations for the security, relative to alternatives, and 3) How well you can effectively undo the overweight risk through counterbalancing.