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Investors with
appreciated securities often wish to hedge - either to protect
their gains and try to gather additional profits or to diversify
without having to pay a large capital gains tax.
An analysis by Twenty-First Securities shows that for stock
purchased before 1984, the best hedge involves a swap with an
embedded collar. The two other possible hedges - options-based
collars and variable forward contracts – produce less favorable
tax consequences.
Hedging
Strategies:
Collars are
generally regarded as the best way to hedge unrealized gains in
stock. There are actually three hedging tools that can produce the
economics of a collar: listed or over-the-counter options,
variable forwards and swaps with embedded options.
Options-based
collars involve the purchase of puts and the sale of calls. With
this strategy, the investor limits the potential for losses below
the put strike price or profits above the call strike price.
A variable
forward involves a contract to sell a security in the future, with
the number of shares to be delivered at maturity varying with the
under- lying share price. The contract effectively has a collar
embedded in it.
Swaps are the
third tool. The swap Twenty-First Securities suggests would be a
contractual arrangement with payments referenced to a specified
equity covering a notional amount. Under the swap agreement, the
investor agrees to pay a dealer any profits over a specified
amount generated by the stock. The dealer in turn agrees to make
payments to the investor equal to the amount of any losses (in
excess of a specified amount) on the shares, plus an
interest-based fee on the notional amount. This structure can create the economics of a collar.
Tax
Consequences:
If the underlying
stock should decline in value, all three hedging strategies
produce essentially the same tax treatment.
If the hedge was properly structured with a term of more than 12 months, then the stock decline would produce a gain on the
hedge, and this gain should be a long-term capital gain.
If the underlying
stock should gain value, then swaps receive more generous
treatment than either forwards or options.
In this situation, an option-based collar or forward would
produce a capital loss, which would be subject to capital loss
limitations. In
contrast, with a swap, the payments made under the terms of the
agreement would be treated as ordinary; thus, they would be
deducted against ordinary income and not be subject to capital
loss limitations. It
should be noted that a termination of the swap agreement would be
treated as capital in nature. With proper planning, therefore, a
swap investor should be able to recognize either a capital gain or
an ordinary loss.
For example,
suppose that XYZ is selling at $50 per share, the investor
constructs a hedge using an options-based collar or variable
forward, and XYZ climbs to $60. The strategy would create $10 of
long-term gain (on the stock), taxed at 15%, and $10 of long-term
loss (on the collar), producing a tax deduction of 15% if applied
against long-term gains. In
rare cases, if the loss on the collar were applied against
short-term gains, it might produce a tax deduction of 35%.
In most cases, the gain on the stock would be evenly
balanced by the loss on the hedge, but that loss would be subject
to capital loss limitations.
This strategy is viable but not ideal.
In contrast,
suppose that XYZ is selling at $50 per share, the investor
constructs a hedge using a swap, and the price of XYZ climbs to
$60. In this case,
the strategy would create $10 of long-term capital gain (on the
stock), taxed at 15% and $10 of ordinary loss (on the hedge),
producing a tax deduction of 35%.
So the gain on the stock would be more than balanced by a
loss on the hedge: in fact, every $1 increase in the price of the
stock would actually produce an additional 20¢ in tax savings.
Hedging
and Monetization:
In addition to
hedging, many investors with appreciated stock wish to withdraw
money from their positions. Such investors may choose to monetize, or borrow against,
their appreciated stock. Borrowing
creates interest expense. Investors
can monetize with any of the three basic hedging strategies by
borrowing against the hedged position, but the treatment of the
interest expense will vary, depending on how the hedge is
constructed.
In certain cases,
Federal Reserve rules limit investors’ ability to monetize with
options-based collars. For this reason, and through the force of general usage, many
investors wishing to borrow rely on prepaid
variable forward contracts. However,
with this strategy, the nature of the contract automatically captures all carrying costs as capital losses rather
than interest expense. (The
costs of the strategy are netted in the discounting of the forward
price and are a reduction in capital gains).
As a result, investors who use this tool may never be able
to deduct the carrying charges.
In the analysis of Twenty-First Securities, this approach
is too expensive in terms of taxes.
For example,
suppose XYZ is priced at $100 and the investor creates the
economics of a zero-cost collar using a prepaid variable forward
with an embedded put at $100 and an embedded call at $150.
If XYZ at expiration is less than $100, then the investor
could sell the stock at $85.
The price of the prepaid variable forward is $85.
Because of the monetization, the strategy would produce $15
less in long-term gains than a zero-cost collar would produce
without monetization. So
before taxes, the cost of the monetization would be $15.
After taxes, however, the cost of the monetization would be
$12.75.
In contrast,
suppose XYZ is priced at $100 and the investor creates the same
zero-cost collar with a put at $100 and a call at $150; only in
this case, the investor creates the collar using a swap (or a
“regular” forward, or an options-based collar), and the
monetization is completely separate.
With this type of strategy, the interest expense associated
with a monetization might still be $15, but the after-tax cost
would be only $9.75.
If a variable
forward becomes necessary for some reason, it should not be
prepaid; rather, the monetization should be effectuated through a
separate borrowing. In
terms of tax consequences, a prepaid variable forward is inferior
to the combination of a “plain vanilla” variable forward plus
a separate borrowing, or an option-based collar plus a borrowing,
or a swap with a borrowing. With any of these strategies, the investor should be able to
deduct the carrying costs. The
combination of this benefit with the generous tax treatment
afforded directly to the swap as a hedge usually makes swaps the
preferred approach, whether or not the investor chooses to
monetize.
Swaps
Are Itemized Deductions:
Investors who are
contemplating swaps should be aware of certain possible negative
ramifications. The tradeoff for having the loss be treated as
ordinary is that then the loss, like “other” itemized
deductions, is subject to certain limitations. First, “other”
itemized deductions can be taken only to the extent that in total
they exceed 2% of a taxpayer’s adjusted gross income. Once this
hurdle is met, the deductible amount is reduced by 3% of the
taxpayer’s adjusted gross income. In addition, the deduction is
totally disallowed for alternative minimum tax purposes. Finally, an ordinary deduction must be taken in the year in
which it is incurred. The
investor must determine whether it is better to have an ordinary
deduction, subject to these limitations, or to have a capital
loss. The swap can be structured to afford the investor either
one. Additionally, all receipts are taxable as ordinary
income at the time of receipt.
Not all investors
are eligible to participate in swaps and the eligibility
requirements are somewhat complex. In general, most dealers
require that a swap involve a minimum of $3 million notional
value. In addition,
for an individual to qualify as a swap participant, typically he
or she must have “gross” balance sheet assets of $10 million.
A
Clear Choice:
Swaps, forwards
and options-based collars are all economically robust, but swaps
have the potential to produce the best after-tax results.
With a swap, if the underlying security depreciates in
value, the gain on the hedge would be long-term capital gain.
If the underlying security increases in value, the loss on
the hedge may be ordinary or capital, whichever the investor
desires. Options-based
collars and variable forwards incur approximately the same
treatment if the stock declines, but they incur harsher treatment
if the stock gains value. For
this reason, swaps are clearly the preferred tool for hedging
pre-1984 equity positions.
For an interactive overview of
hedging and monetizing possibilities for different types of
appreciated securities, see Twenty-First Securities' low-basis
stock hedging decision tree.
This article and
other articles herein are provided for
information purposes only. They are not intended to be
an offer to engage in any securities transactions or to
provide specific financial, legal or tax advice. Articles
may have been rendered partly inaccurate by events that have
occurred since publication. Investors should consult
their advisers before acting on any topics discussed herein.
Options
involve risk
and are not suitable for all
investors. Before engaging in an options
transaction, investors must review the booklet "Characteristics
and Risks of Standardized Options". |
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