Tax – BluePointe Capital Management

An Introduction to Traditional Direct Indexing Strategies

Traditional direct indexing strategies generally involve buying individual stocks within an index (e.g. the S&P 500, Russell 3000, etc.), with the goal of investing in enough holdings to track performance closely with the index performance. As the securities within the index each rise or fall, the portfolio of securities are rebalanced in a tax-aware manner (i.e. selling stocks that have declined to realize capital losses, which can be used to offset capital gains). The proceeds are reinvested to maintain the overall close resemblance to the index, but the position is a new holding tax lot that can be a potential source of losses to realize.

The benefit over holding the index in a single ETF position is that each security presents an opportunity for the manager to proactively manage the potential capital gains impact in the portfolio. The capital losses achieved in the strategy can be used to offset capital gains in the strategy, with the excess losses available to offset Schedule D capital gains generated by other investments.

Since equities typically rise over time, the drawback with this strategy is that the loss-harvesting benefits eventually diminish as fewer losses remain in the portfolio to be realized.

Introducing Long/Short Strategies: A 130/30 Example

Long/short strategies expand on long-only equity strategies by incorporating short selling and investing the short sale proceeds into additional long holdings. One of the first long/short hedge funds was founded in 1949 and has since expanded to many different variations of the original long/short hedge fund.

The following chart illustrates a $100 investment in a 130/30 strategy. This structure maintains an overall market exposure of $100 to give the investors the same level of market risk.

Tax aware long-short solutions incorporate tax-loss harvesting into the long-short strategy. This tax-aware solution is not a hedge fund – it is executed in a separately managed account (SMA).

Long/short tax-aware strategies benefit from:

More alpha potential with the addition of short positions.
A higher number of individual holdings and more opportunities to rebalance/trade and realize losses.
Losses in rising markets and a more consistent execution of capital losses, regardless of whether the equity markets are rising or falling.
The likely acceleration of tax benefits compared with a long-only direct indexing strategy.

These strategies also come with other risks and costs, including:

Performance should not be expected to track with the performance of the underlying index, like a direct-indexing strategy; it increases the volatility relative to an index ETF.
Short selling in any strategy must be executed with care to mitigate the potential for significant losses.
The overall complexity of short selling, managing margin requirements while also adhering to tax rules should be executed by a manager with the experience and infrastructure to handle it.
Short sales incur borrowing costs. The complexity of the strategies also commands a higher management fee over direct indexing.

Note: Further extension of the leverage (to 145/45, 200/100, etc.) tends to amplify the potential benefits, risks and costs.

Tax-Aware Investment Solutions Have Evolved – Is There a Solution for Your Needs?

Tax-aware solutions are an important part of managing investments in a tax-efficient way. There are many scenarios where an investor should consider one of them, including:

You desire tax efficient exposure to an equity index.
You want to rebalance your current portfolio holdings to be more tax efficient.
You have appreciated stock you want to diversify to be more tax efficient.
You have other capital gains (recent or upcoming), and you want to mitigate your tax burden.

Is a Long/Short Strategy Right for You?

A long/short strategy is not for everyone. It requires a high level of sophistication and active management compared to traditional long-only strategies. However, it can be a powerful tool to enhance returns and improve diversification tax efficiently.

Before adopting a long/short strategy, you should consider your investment goals, risk tolerance and time horizon. This strategy is best suited for investors who are comfortable with leverage and short selling, and who have a tax advisor to advise them on their individual tax situation.

BluePointe Capital Management can assist with implementing a long/short strategy, as well as provide custom investment strategies based on your goals, values and objectives. Contact us to learn more.

Disclaimer

The information provided herein is for informational purposes only and does not constitute financial, investment or legal advice. Investment advice can only be rendered after delivery of BluePointe Capital Management, LLC’s disclosure statement (Form ADV Part 2) and execution of an investment advisory agreement between the client and BluePointe Capital Management, LLC.

The net investment income tax (NIIT) has been a weight on the back of high-income earners for a little more than a decade, but that long time in force has provided tax professionals with ample time to formulate strategies investors can use to reduce the impact of this levy.

A Quick History

The NIIT is a revenue-raising offset that was put into place by the Health Care and Education Reconciliation Act of 2010 to help fund Medicare. The NIIT – which applies to passive income from stock dividends, bond interest, rental income and more – is a 3.8% tax on the lesser of net investment income or the excess of your modified adjusted gross income (MAGI) over your applicable threshold. Those thresholds are:

$200,000 for single filers and heads of household.
$250,000 for married couples filing jointly and widow(er)s with a dependent child
$125,000 for married couples filing separately.

The tax also applies to the lesser of undistributed net investment income or the excess of adjusted gross income (AGI) over the beginning dollar amount of the estate or trust’s highest tax bracket ($15,200 in 2024).

Strategies for Minimizing NIIT

High-income earners who want to reduce the impact of net investment income tax have a few methods at their disposal, primarily revolving around either reducing MAGI or effectively managing investments. These options include:

Investing in tax-exempt debt: Municipal bonds are exempt from federal income taxes – and, depending on where you live and the issuer of the municipal bonds, state and local taxes. But municipal bonds have another advantage: Their interest income isn’t subject to the NIIT. (Also, munis’ interest doesn’t increase AGI, so it’s helpful from that tax perspective, too.)
Using tax-efficient investments: Normal buying and selling within many mutual funds often results in capital gains, which tax regulations dictate must be distributed to the fund’s shareholders. However, tax-managed mutual funds and exchange-traded funds (ETFs) minimize or eliminate capital gains distributions, helping you minimize these taxable events.
Tax-loss harvesting: You can sell investments that have experienced a decline in value to below their original cost basis, thus offsetting some or all of your capital gains and reducing AGI. (If you do use this strategy, make sure you comply with the IRS’s wash-sale rules.)
Contributing to retirement accounts: Contributing to retirement accounts, including 401(k) plans and individual retirement accounts (IRAs) can reduce your MAGI. However, this does not apply to Roth versions, such as Roth IRAs or Roth 401(k)s. Also worth noting for investors in retirement: Distributions from these vehicles aren’t subject to NIIT, either, but they can increase your MAGI.
Donating appreciated assets: Donating appreciated assets, such as stocks or mutual funds, directly to charity or donor advised funds can provide double tax benefits. Donors receive a charitable deduction for the fair market value of the donated assets, which reduces taxable income subject to the NIIT. They also avoid paying capital gains tax on the appreciation.

Navigating the complexities of the NIIT requires a strategic approach, especially for high-income earners looking to minimize their tax liabilities. BluePointe Capital specializes in providing tax-efficient investment advice and planning that enables high-income earners to optimize their investment outcomes while contributing to their long-term financial health and stability.