Current Options
Disclosure Document
(PDF Format) 

Swaps for Pre-1984 Stock

April 2001    
revised June 2003     


  Proposed Regs Could Makes Swaps Less Attractive (February 2004)

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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