Long/short mission accomplished: it’s time to delever

The Bottom Line:

• Offsetting capital gains from a near-term liquidity event may require abundant capital losses, which in some cases can be supplied by a long/short tax-managed portfolio.
• Once the investor's near-term goal has been achieved, it may be prudent and cost effective to delever the long/short portfolio.
• Like charting a rocket’s re-entry, engineering a deleverage plan for a portfolio is analytical, nuanced and consequential.

Adding leverage to a long-only portfolio is like strapping on a rocket. It may substantially enhance the portfolio’s capacity to realize capital losses. When they are used to offset capital gains elsewhere in an investor’s portfolio, these capital losses may lead to an increase in the investor’s after-tax returns.

The need for abundant losses may be punctual: think about the sale of a business or the rapid derisking of an equity-heavy portfolio. Once the acute need for capital losses has been satisfied, reducing leverage or eliminating it entirely may make sense for an investor who wants to lower financing costs, control risk or bequeath the portfolio---short positions not eligible for a basis step up, and gains realized from short-term positions are always taxed at the short-term rate.

Re-entry is the hard part

Safely bringing a rocket back from space requires accuracy; an error in speed or direction during reentry could cause the rocket to burn up or ricochet back into orbit. In the same way, reducing leverage in an investment portfolio must be thoughtfully planned to balance capital gains taxes with borrowing expenses and risks.

Imagine a hypothetical investor holding a 200/100 portfolio that has $30 mm in gross exposure, $20 mm long and $10 mm short. Their long positions are established with $10 million of investor funds or securities extended with $10 million of borrowed funds. Short positions are obtained by borrowing securities and selling them, with funds from the short sale deposited in an interest-paying account.

The investor sold their business a month ago, using a portion of the losses from their long/short portfolio to offset the capital gains from the sale. With a diminished need for capital losses, they decide to reduce leverage to 130/30 to lower risk and fees. The new level of leverage is calibrated to generate losses adequate to offset a moderate, steady stream of gains from hedge fund holdings.

The reduction means selling $7 mm in long positions and repaying the borrowed funds used to buy them, while covering $7 mm in short positions by buying back the borrowed securities with funds set aside from their sale and returning the securities to the lender. Either action may trigger a tax liability.

Suppose there are $4 mm in long-term gains embedded in the long positions that are targeted for sale and $3 mm in short-term gains embedded in positions slated to be covered. As of tax year 2026, the highest federal rates of 23.8% and 40.8% for short- and long-term capital gains, instant delevering to 130/30 could lead to a tax bill exceeding $2.2 million. State taxes could drive that number higher. However, gradual unwinding may allow for further loss generation, potentially reducing the tax bill by offsetting capital gains from the delevering process.

Like a rocket’s journey to outer space and back, the trajectory of a levered, tax-managed portfolio is rugged and changeable, demanding careful planning and course corrections along the way. A change of fortune may prompt an investor to add leverage to Direct Indexing account to generate more losses. Just as easily, an investor may want to delever after carrying forward a treasure trove of capital losses amassed in a market downturn. To learn more about how BlackRock helps investors manage the full life cycle of a levered, tax-managed investment, see visit Aperio Tax-Managed Solutions page.