In a previous article I discussed what can happen when the concentration of a stock in an investment portfolio has become too high. The simplest solution is to sell some amount of the stock and pay the taxes, reminding yourself how much the stock’s growth (even after taxes) has increased your wealth. But there are more complex ways to defer those taxes, perhaps to later years when the impact on your overall taxes may be lower.

One approach is direct indexing, either in its basic form or additionally including long-short active management with a margin loan or variable prepaid forward (VPF) contract. Both involve the creation of a separately managed account (called an SMA) that is used both to create a diversified portfolio from the sale of the concentrated stock and to generate tax losses that are intended to offset the gains.

Let’s start with the simpler technique. Suppose you work for Apple and have accumulated $1 million of Apple stock originally costing only $100,000 years before. Your goal is to diversify the Apple stock into a diversified portfolio of stocks similar to the S&P 500 while managing the taxes owed each year. You first move the Apple stock into an SMA, which sells either a fixed amount of shares (typically 10%-20%) or just the number of shares resulting in some maximum amount of realized (taxable) gains. The SMA manager uses the cash from the sale to buy the 500 stocks in the S&P 500 in their respective proportions (except possibly for Apple in this case). During the year the manager sells stocks in the S&P 500 that experience losses. At the end of the year, the losses reduce the gains from the Apple stock sale, resulting in a lower tax burden. The process is then repeated annually until the concentration is down to an acceptable level.

Will this strategy completely cancel out the taxes from the Apple stock gains for that year? Not likely unless the entire stock market crashes. But individual stock prices do go up and down even during bull markets. The SMA manager can periodically sell the losers and replace them later in the year, harvesting those losses to apply against the gain from the concentrated stock sale. (Note that there are strict rules that must be followed to avoid the IRS disqualifying the losses).

Is it worth employing this strategy? It will reduce the concentrated stock position and offset some of the taxes. But there are also management fees incurred. Recognize also that we are talking about tax deferral, not elimination. The SMA is expected to grow similarly to its benchmark. Eventually when you need to liquidate portions of the account for retirement or other expenses, taxes on the gains will come due.

The long-short approach is even more complex. You take out a margin loan against the concentrated position and use that to fund the SMA. A variant is to purchase a VPF contract from an investment bank for the same purpose. Neither loan is taxable but can involve costly fees.

In this case the SMA doesn’t simply harvest losses but instead sells short a percentage of the portfolio to accelerate the losses. The manager must actively determine which stocks to short and which to buy long. It’s harder to try to generate greater tax losses while at the same time achieve market benchmark returns. Manager selection thus becomes very important.

There are additional techniques for managing the taxes associated with reducing concentrated stock risk. All these various strategies do achieve that goal. But due diligence is necessary to ensure that the cost of the solution does not exceed the tax savings.

(Artie Green is founder of Cognizant Wealth Advisors dba Perigon Wealth Management, LLC, a registered investment advisor. This information does not constitute investment, legal or tax advice and should not be used as a substitute for the advice of a professional legal or tax advisor. Any tax statements contained herein are not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor. Perigon and its directors, officers, agents and employees are not permitted to render tax or legal advice. More information about the firm can be found in its Form ADV Part 2, which is available upon request by calling 877-977-2555 or by emailing compliance@perigonwealth.com.)