Monetizing Large Capital Gains Without Incurring Large Tax Bill

US equities have performed very well for investors over the past couple of years. From its recent bottom on October 12, 2022, the S&P 500 index has provided total return of more than 76% with dividends reinvested. This is just over 30% annualized return, historically very good number[1]. 

Certain stocks have gone up by multiple times that – the best performers in the S&P 500 are up several hundred percent this year alone. We don’t imply here that it’s time to take the money out of the market and run, but life requires cash outlays, sometimes large. It is understandable if some investors would be looking for ways to monetize these gains. For instance, if you were lucky or smart enough to buy into the big winners early and now have a rather large position with substantial capital gains attached to it, or if you were compensated with shares of your firm that have now vested and represent significant part of your net worth, you may be one of those investors. 

But selling these appreciated stocks outright will entail a sizable capital gains tax. Fortunately, there are ways to monetize your asset and avoid or postpone those capital gains taxes. Each has its own pluses and minuses (risks). Which one to choose depends on your particular situation: 1) what is your timeframe for selling down the stock and raising cash; 2) how much cash do you need relative to the value of the asset; 3) what does the rest of your portfolio looks like in terms of size and exposure; 4) what is your view of the stock’s potential for further gains. Below we outline three strategies that may provide the right solution.

Securities Based Lending

This has been a strategy used by the super wealthy for a long time, but it has become available to a wider audience. Securities Based Lending (or SBL) involves receiving a loan from a financial institution and pledging the appreciated stock as a collateral. This strategy would be appropriate if one needs relatively large amount within a short timeframe, such as for a real estate purchase. The borrower retains the ownership of the assets, and receives the cash. Because they are heavily collateralized, these loans are cheaper (have lower interest rates) than other sources of financing, such as home equity loans. Potential risks here are that SBLs are typically floating rate, so a rise in interest rates would make the interest costs higher; also, if the stock falls in value below certain level, the bank may require further collateral. The loan-to-value ratio depends on the riskiness of the collateral. On the positive side, these can be arranged in a very short time and thus can be a quick source of substantial liquidity. 

Direct Indexing

Direct Indexing has also been around for a while, but it wasn’t until technological developments and the ability to trade fractional shares lowered its cost enough to make it available to the average investor. As the name implies, Direct Indexing (DI) involves buying each of the constituents in an index (e.g., the S&P 500), instead of buying a mutual fund or an ETF that tracks that index. As an example, an executive with a large position in a legacy stock would fund an account with other assets that will be managed using direct indexing. The main objective of the DI portfolio is to track the performance of the index, while generating capital losses by selling stocks when they fall below their purchase price. These tax losses can then be used to offset gains generated from selling the appreciated stock. By targeting certain amount of losses each year, one can create a glidepath for the sell-down of the highly appreciated stock. This process is lengthier than an SBL, as it may take multiple years to convert into cash, depending on the size of the stock vs. the rest of the portfolio. DI also allows for customization of the portfolio the way mutual funds or ETFs don’t. While DI is conceptually simple, it requires setting up the right parameters and having the technology to implement it effectively. DI managers charge fees for their service and there is a minimum investment required to open an account with them. But for the right investor, the benefits can far outweigh the extra costs. 

Selling Covered Calls

This strategy is used a lot, but generates a more limited amount of cash, and is the least predictable in terms of outcome. One may consider it if the above two strategies are not viable for some reasons. The concept here is to sell call options with underlying being the appreciated stock. It generates cash through the option premium the seller of the call options receives. The size of the option premium depends, among other things, on the volatility of the stock in question. All else equal, the higher the volatility, the higher the premium, hence the higher the cash proceeds. But the stock’s volatility is also the source of one of the main risks to the strategy. If the options sold expire out of the money, all is good, the investor keeps the shares and the proceeds from the premium; rinse and repeat. If, however, the stock appreciates and the option ends up in the money, it will likely be assigned (i.e. the seller has to deliver the shares). In this case, capital gains taxes will be due on the sold shares plus the option premium. From the above, it is clear that this strategy is most appropriate for investors who are indifferent as to whether they continue to hold or sell the shares. Further, it is likely to fare better in a flat or bear market, rather than in a rising market. On the positive side, the investor can control the size of the potential capital gains generated by this strategy by selecting the number of options sold. 

Bottom line, there are viable options to manage and monetize large capital gains without necessarily selling the stock outright and incurring the tax liability. Investors need to think carefully what option is best for their particular circumstances. As always, when in doubt, it is a good idea to consult with your financial advisor. 

Disclosures and Disclaimers: This content was developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice. A professional adviser should be consulted before implementing any of the options presented. Neither the information presented here nor any opinion expressed constitutes a recommendation by us of a specific investment or the purchase or sale of any securities. Past performance may not be indicative of future results. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. Investing in options carries substantial risks, including a loss of one’s entire investment. An option writer may be assigned an exercise at any time during the period the option is exercisable.