#60 | Mitigating Taxes In a Concentrated Stock Position

Guest Profile

Alex Koury CFP®, CERTIFIED FINANCIAL PLANNER® professional and Wealth Manager in Scottsdale, has worked in the financial services industry for fifteen years as a financial advisor and Financial Planner. He holds Series 7, 9, 10 & 66 securities registrations– and is a Registered Representative with Commonwealth Financial Network®.

Transcript

Protecting and Preserving Wealth – Mitigating Taxes In a Concentrated Stock Position

Speakers: Jon Gay, Bruce Hosler, & Alex Koury

[Music Playing]

Jon Gay:

Welcome back to Protecting and Preserving Wealth. I’m Jon Gay, and I’m joined by Bruce Hosler and Alex Koury of Hosler Wealth Management. Always good to be with both of you guys.

Bruce Hosler:

Thank you, Jon. It’s great to be with you.

Alex Koury:

Same here, Jon. Hope all is well.

Jon Gay:

Alright, so today, we’re going to cover a topic that we’ve really hit on in previous episodes, but it can’t be underscored the importance of it, and that is solving for the concentrated stock position.

When you’re invested, you do not want to be over concentrated in one area, it’s the proverbial putting all your eggs in one basket. You want to be diversified. So, diversification is our topic today. Bruce, where do you want to start?

Bruce Hosler:

Jon, the stock market has been great this year and we have been meeting with new clients, and we are finding a lot of people that have been successful in their investments, whether it be with Apple or Nvidia or Tesla.

And what happens is when someone invests in one of these stocks that has done well and they’ve held the position for a few years, all of a sudden, they have a problem, and the problem they have is capital gains tax, and they want to avoid the capital gains tax so they don’t sell the position, and so it just festers and becomes worse. And now, this concentrated stock position becomes dominant in their portfolio, and they are struggling with what the answers are.

So, Alex and I want to talk about what they can do on some of these positions. Foundationally, I want to start off with (and Alex, I’m going to have you kind of jump in here with me) in Arizona, we are a community property state, and sometimes, the clients will make a decision: “Bruce and Alex, I love this stock (let’s say it’s Apple), I love this position, I don’t ever want to sell it. I just want to hold it forever.”

Well, one of the things we can do is if we hold it until one of the spouses dies in the community property states, the surviving spouse can get a full step up in basis and not have to pay any capital gains tax. Alex, do you want to talk about that for a second?

Alex Koury:

Yeah. So, what we want to be aware of is when it comes to your capital gains taxes, and a reason why you maybe don’t want to sell your stock at all is at the death of the first owner of that stock if you’re married or joint tendency – again, when one of the original owners dies, there’s what’s called a step up in basis to the date of death of the first person that passes away.

And that will raise your cost basis up to the date of death, and that helps eliminate some of that additional capital gain tax risk you may have on that specific position.

Bruce Hosler:

So, that’s a foundational piece if people are old enough, but what if they’re younger? We have some other strategies.

Alex Koury:

So, in exchange fund strategy, what a client or investor is exchanging into is actually a basket of stocks. So, it could be based on the S&P 500 as an example. What that achieves for a client is number one, let’s say you have a stock like Apple, let’s say it’s worth a million dollars today – you can take that stock, not sell any of it all, not generate any capital gains, and you move it into this exchange fund for immediate shares of let’s say, Nvidia, Google, Amazon (this is a diversified basket of stocks).

And in that exchange, we’re not realizing any capital gains. You still own that particular stock, but your risk actually becomes diversified at that point because now, you actually hold or own in exchange for your share of Apple stock a basket of stocks instead.

And the nice thing about that is over time, what that allows for if you think about it, is diversification, number one, a better capital gains tax strategy because now, we can do better tax planning for you around those bigger positions in your non-qualified brokerage accounts and other advisory accounts.

And at the end of the day, if you decide after six years or so that you still want to keep your original stock, and you want to give the exchange fund back, you can actually still maintain that individual holding at a later date in time. So, there’s a lot of reasons why you may want to consider that as part of your strategy.

There are some qualifications for that. Number one, you must be what’s called a “qualified purchaser,” and that means you must have a liquid net worth of over $5 million for this specific strategy. But it may be attractive for folks that do like the idea of diversification, but they don’t want to have to sell all their stock up front and pay that big capital gains tax.

Bruce Hosler:

So, I want to make sure that we reiterate folks: this is a non-taxable event. So, you take your stock, you contribute it to the exchange fund – in return, the exchange fund gives you shares of the exchange fund, that is a non-taxable event to be able to diversify your risk away from your concentrated stock position.

Jon Gay:

We’ve talked about the magnificent seven in previous podcasts, and a lot of the examples you’re using today, Apple and Nvidia, things like that – if you have X amount of stock in one of these companies and it continues to keep gaining and gaining and gaining and rising, now you may have a disproportionate amount of your portfolio in this stock because it’s gone up so much in value.

These strategies, the two of you are discussing today, really have to do with mitigating that risk and doing it in a tax-free way.

Bruce Hosler:

Yes, diversification, we’re avoiding the concentrated stock position of having … you have a $2 million portfolio and half of it is in one individual stock. That’s too much risk in one individual business, be it as good as it was.

I mean, I think back in the day when I was a younger advisor back in the 1990s. GE was a company that you would want to own. Well, you look at GE today and it’s fallen from grace. You may not want to continue to own that. So, you want to diversify away from these positions.

Maybe you think Apple is invincible or Nvidia or whatever today, but sometime in the future, 5 years, 10 years, 20 years, it may not be as good as it is today, and you may not want to continue to hold that. You have to find an ability to get out of that position.

I want to move on to our next idea in this area of dealing with mitigating the concentrated stock risk in a portfolio. And that is with direct indexing where we can take your stock position, and again, involve it in a direct indexing fund or investment portfolio. Alex, tell our listeners about direct indexing.

Alex Koury:

So, what direct indexing actually is:  let’s take for example, again, the S&P 500 index. Now, in this example, you actually would own all 500 stocks in the S&P 500 index. And why would that be advantageous? Why wouldn’t you just buy some other type of index fund instead?

Well, in an index fund, let’s just say in the S&P 500 in general, we know that not all stocks in any year are profitable. Some of them are going to be down. They may generate some losses for you in your portfolio, and some of them are going to be up.

When you own it in an ETF exchange traded fund wrapper, whatever the S&P 500 returns is what you get as a net number. But if you can imagine, there’s going to be stocks in your portfolio in the direct indexing model that are going to generate losses in that portfolio. And what a direct indexing fund actually allows you to do, is take those capital losses to net them against the capital gains you have in that individual stock portfolio.

So, over time, it’s a time strategy that over time, you can liquidate your stock, use those losses that are generated from the S&P 500 index of the losers of the index that year, and then have a zero-capital gain risk going forward. And we can do that over many, many years to unwind those larger positions in this direct indexing strategy.

Bruce Hosler:

So, it allows you to diversify your concentrated stock position without just selling at a gain. You’ll still have to sell those positions at a gain, but you’ll have accompanying losses in the direct indexing portfolio that offset the gains in your concentrated stock position. So, slowly, we unwind that concentrated position using the losses of the other positions in the portfolio. Very, very good, folks.

Let’s talk about the unified managed accounts. Unified managed accounts allow us to put together your portfolio, whether it’s individual stocks, some ETFs, some mutual funds, and again, the same type of thing works where inside that unified account, we can buy or sell stocks, ETFs, mutual funds that have had gains, and sell the ones that have had losses in the same tax year, offsetting those capital gains, allowing you again to diversify your loss.

I don’t know, Alex, do you have any other thoughts you want to talk about the UMA accounts?

Alex Koury:

The UMA, the unified managed account strategy, is really diversified among actively managed SMAs or separately managed accounts, and also some of our own managed accounts that we have for our clients as well.

So, it’s a little bit like the direct indexing model, but a little bit more actively managed in sets. You don’t just get the index, you actually get actively managed stocks, ETFs, and mutual funds as an example there, but it allows you to do the same exact thing- realize and recognize over time capital losses every year to offset your capital gains risk in your individual stock portfolio just as well.

By the end of the process, you would be fully engaged in this UMA model instead, again, achieving diversification and long-term growth prospects that you have. I mean, you’ve taken a lot of risks just to earn that return or that big unrealized capital gain in those bigger stock positions.

But then the question of course, just becomes again, how do you unwind these things? What are the strategies around that? What makes sense from a perspective of your tax plan every year? How do you pay less tax every year? These are some of the ways you can actually achieve that.

Bruce Hosler:

I want to make sure that we clarify SMA is a separately managed account, so that’s where we can, as advisors, hire money managers in a specific area. Maybe they specialize in small cap or mid cap or maybe even some private equity or something like that.

But there’s a third-party manager, a separately managed account that is held inside of the UMA and those managers can be offsetting losses against gains, harvesting gains, harvesting losses, and they can actively do that for us.

Let’s move on to our last and final kind of topic for this show this week: charitable giving.

So, certainly, if you’ve had a very good year or you are going to contemplate selling something at a large capital gain, we want to talk about donor-advised funds very quickly and charitable lead and remainder trusts. So, a charitable remainder trust or a charitable lead trust.

Folks, if you have a concentrated or highly appreciated stock position and you’re contemplating a donor-advised fund, you can donate your stock to your donor-advised fund without recognizing the capital gain, and you receive the donation on the fair market value of your investment.

So, if you invest in a position and it grows, let’s say it doubles, and then you give that doubled amount away to your donor-advised fund, now you can receive a tax deduction for that year equal to the fair market value of that position that you gave away. And you can then write that off against your ordinary income up to 50% of your ordinary income.

So, you have to have enough ordinary income.

Jon Gay:

Well, Bruce, I know moving to tax free is a passion of yours and the team at Hosler Wealth Management. In fact, it’s even the name of your book.

Bruce Hosler:

We love increasing your income to take advantage of your donor-advised fund by making a Roth conversion. So, we can cover you every way, whether we’re increasing your income or minimizing your income with the deduction on a donor-advised fund.

The other one with a charitable lead or charitable remainder trust, those are great. You can give your position away to your charitable remainder trust, and again, take income for your life and your spouse’s life, maybe even for part of the lives of your children. It’s a great source of income, but you still get a charitable donation on that. And so, there’s a lot of planning that can go into these concentrated positions or minimize.

Alex, is there anything on charitable giving that you want to comment on?

Alex Koury:

Those are the main ones. I think a lot of people are used to giving cash. You make a donation, you give cash. That’s typically how it goes. But again, think of your taxable brokerage accounts that you have and look at your appreciated assets in those portfolios, and consider instead using those more strategically to gift those stocks away that you could give away over time.

And that way you get a tax benefit upfront, the charity gets its benefit when you donate out of the donor-advised fund device fund as an example. It’s a great tool you can use for your family to get around, say during the holiday season, and talk about what charities mean the most to you and give a little bit away every year.

And it could be another legacy asset that you can actually grow over time just as well to be something that would help your family and others remind them of you in those times of giving when you’re no longer around.

Bruce Hosler:

And that’s an important part that I want to remind our listeners here – on the donor-advised fund, you don’t have to give all that money to a charity that year. You have the ability over a number of years to carve off a portion of that each year.

Let’s say you have a big position, maybe it’s grown to $50,000 or $100,000, you’re like, “Bruce, I don’t want to give that all to one charity this year.” That’s okay, folks. You can give it to your donor-advised fund and then give out $5,000 a year or $10,000 a year to the charities that you love and want to support.

And if somebody else comes up, you can give that away, but you can make your giving last over a number of years, even though you made a big donation in the first year and you had a big deduction, which we can use to help you make a Roth conversion or do other tax planning with.

Jon Gay:

It’s interesting, as we got into today’s podcast, I was thinking about how diversification is so important and not being concentrated in one area, but you two have really dove into avoiding taxes. I know the book you wrote, Bruce, is Moving to Tax-Free.

There are so many strategies here and it really speaks to your expertise at Hosler Wealth Management as far as all these different vehicles to help anybody with their individual situation.

Bruce, if our listeners want to get in touch with you and the team to talk about any of this, we’re going to give your contact information in just a moment, but before we do, a quick disclaimer. This material is intended for informational educational purposes only and should not be construed as investment advice, solicitation, or recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation. Diversification does not assure profit or protect against a loss in declining markets, and diversification cannot guarantee that any objective or, goal will be achieved. All right, Bruce, how do our listeners best find you? For more information?

Bruce Hosler:

Hey, they can find us at the website at hoslerwm.com or call us at one of the offices in Scottsdale, (480) 994-7342, or in Prescott, they can reach us at (928) 778-7666.

Jon Gay:

Great stuff, gentlemen. We’ll talk again in a couple of weeks.

Bruce Hosler:

Thanks, Jon.

Alex Koury:

Thanks John.

Jon Gay:

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