The Overlooked Power of Tax-Aware Investing

Many investors only think about taxes once a year—or perhaps when setting up an estate plan. But this leaves a lot on the table. An investment portfolio built and managed with a tax-aware focus can deliver considerable savings, both on your annual tax return and over the course of your lifetime. To this end, investors should be aware of:

• Tax-inefficient assets
• Tax-efficient alternatives
• Levers for deferring and avoiding capital gains taxes
• Strategies from the frontier of tax-aware investing
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Tax-Inefficient Assets

• Taxable Bonds: Touted as an essential diversifying asset class to complement a stock-heavy portfolio, the income they generate is subject to the investor’s ordinary income tax rate—generally the highest.
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• Mutual Funds: (particularly actively managed stock funds): Every purchase and sale inside a mutual fund flows through to its shareholders, who are then subject to taxable distributions each year. In many cases, a shareholder ends up paying for the capital gains of earlier shareholders in the fund.
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• Dividend-Paying Stocks: These impose mandatory taxable distributions on shareholders, regardless of whether they choose to reinvest. In addition, stocks chosen on the basis of dividends alone are nearly guaranteed to underperform the broader market.
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Tax-Efficient Alternatives

• Exchange-Traded Funds (ETFs): Rapidly replacing mutual funds as a superior vehicle, ETFs rarely have to pay distributions. As a result, “what happens in the fund stays in the fund,” deferring most tax liability until the investor sells shares.
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• Commercial Real Estate Funds: Benefit from favorable tax treatment. Much or all of the (relatively high) income they distribute can be treated as a “return of capital.” Depreciation deductions—unique to real estate—can also be passed through to shareholders.
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• Limited Partnerships: In some instances, an identical investment strategy held in an LP may receive more favorable tax treatment than in a fund. (These opportunities are limited to accredited investors.)
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Levers for Deferring and Avoiding Capital Gains Taxes

• Tax-Loss Harvesting: The sale of assets with losses to offset gains in a given tax year. However, since assets tend to increase in value over time, these opportunities will become scarcer.
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• Direct Indexing: Allows investors to own an index-like portfolio with greater tax efficiency, using tax-loss harvesting principles.
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• Exchange Funds: A pooled investor vehicle that allows an investor to contribute concentrated stock positions in exchange for a more diversified portfolio.
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• 1031 Exchanges: After the sale of an investment property, an investor can make a like-kind exchange and buy a replacement property to defer capital gains taxes. Investors who no longer want to manage property themselves can access a range of Delaware Statutory Trusts (DSTs), allowing them to become passive owners of investment real estate.
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• Opportunity Zones: For any kind of capital gain, these investments offer a combination of tax deferral and elimination. Like 1031 exchanges, a number of institutional-caliber investment options are available.

[Given the development of newer and better options (see below), we won’t further discuss the mechanics of the first three strategies above but are happy to compare them point by point privately.]
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Strategies from the Frontier of Tax-Aware Investing

• Generating Capital Losses Without Actually Losing Capital: Finely tuned systematic strategies now allow investors to generate excess tax losses, which they can use to offset gains from their portfolios and other taxable events. (Ask for our white papers on CTAs.)
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• Exchanging Higher Tax Rates (e.g., on Wages) for Lower Tax Rates: These strategies leverage a deep understanding of tax code structures in limited partnerships to transform ordinary income tax liabilities into preferential ones, such as dividends or capital gains. (Available only to Qualified Purchasers. Ask for our white papers on TALP.)
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• Section 351 Exchanges: This provision allows investors to contribute their securities to a new exchange-traded fund without creating a taxable event—achieving a more diversified portfolio in a low-cost, tax-efficient vehicle.
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• Better Liquidity Solutions: Alternatives to common cash substitutes like money market funds and CDs, but subject to preferential capital gains rather than ordinary income tax rates.
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A Changing Tax Landscape—And Staying Ahead of It

Tax rates and the tax code are subject to periodic change, but the pace of innovation in tax mitigation strategies has accelerated. Magnolia’s structure and relationships in the asset management industry allow us to identify these opportunities—often ahead of our peers—and bring them rapidly to our clients.

Whether it’s strategically placing assets in the appropriate account types or implementing advanced tax mitigation strategies, our objective is clear: maximizing your net-of-tax investment returns—what you’re able to keep and pass on to others.

We would be delighted to discuss your individual opportunities, both within your financial plan and in implementing strategies from the frontier of tax-aware investing.

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