Gains Deferral: The Core of Tax Management

Loss harvesting gets all the attention, but it's gains deferral that does most of the work.

I recently defended tax loss harvesting against its critics. But there was a twist. I noted that while tax loss harvesting is well and truly valuable, it is not the star of tax management. That honor belongs to gains deferral. For many folks, this is a bit shocking, 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:

1. 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. 
2. 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, compared to 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.¹

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.

So, let’s put it all together. Well executed gains deferral means prudently holding onto overweighted positions with unrealized gains, and then minimizing the risk and return impact by carefully counterbalancing. It is an optimization problem. And, unlike loss harvesting, your work isn’t done in 30 days. You have to keep monitoring the overweighted positions and evaluating how to counterbalance the overweight for as long as you own the security.

And that’s why gains deferral is hard. Done well, it requires sophisticated optimization analytics.  It is exceedingly difficult to do well manually.² And it’s an open-ended commitment — maybe even a lifelong commitment if you hold overweighted positions till death.

Why don’t we hear more about gains deferral?

Given gains deferral status as the core of efficient tax management, why don’t we hear more about it?

One reason seems clear: implementing gains deferral manually requires a level of attention and care that is only economical for high net worth — or perhaps ultra high net worth portfolios. The good news is that modern automation tools are changing this. Sophisticated gains deferral, like sophisticated loss harvesting, can now be implemented inexpensively and at scale.

But there may be another reason why gains deferral doesn’t get the attention it deserves: Clients may value it less. It appears to be doing nothing. What client wants to pay their advisor for doing nothing? This applies double for legacy holdings — positions that the client transferred in to be managed by the advisor. Why should the client pay an advisor for holding a security that the client bought? The reasoning isn’t sound. Risk-managed gains deferral is really valuable. And hard. But it may not be highly valued by clients.

Having conjectured on why gains deferral doesn’t get the credit it deserves, we’re still a bit puzzled. On this point, we’d especially like to hear from you. Leave comments or reach out to us directly. We’ll share what we learn.

¹ Not everyone will focus on the same characteristics — also called “factors.” Some correspond to plain-English characteristics, like “sector” or “capitalization.” Others are purely mathematical constructs with no obvious real-world counterpart.

² There are cruder approaches to counterbalancing, such as  just underweighting everything else pro rata, or just buying less of whatever you were planning to buy next, but these simple approaches will result in greater risk and performance drift.