IRS plans guidance on trades used to harvest losses against ordinary income

The Internal Revenue Service said Monday that it plans to publish guidance and may take other steps to bar certain trades money managers use to help clients harvest losses and lower tax bills on ordinary income, a move Financial Planning called the most concrete sign yet that federal authorities are preparing to clamp down.

The best-known version belongs to AQR Capital Management—the world's largest hedge fund, the outlet notes—which helped pioneer tax-aware long-short trading and runs the version it calls Delphi Plus; in its notice the agency pointed to certain currency bets and transactions combining equity swaps with futures as among the structures it is studying. Whether AQR's underlying trades already work around the agency's concerns is unclear from the notice, and representatives for the firm did not reply to messages seeking comment; AQR has previously said it adapts strategies "to operate within all relevant guidance and regulations."

Ordinary income carries some of the highest rates in the code and arrives without the flexibility a portfolio offers—wages, salaries and bonuses show up when they show up—so producing for them what tax-aware managers already produce for capital gains has become Wall Street's next frontier, the "holy grail" in the words of Orso Partners portfolio manager Nathan Koppikar.

Koppikar is a short seller who has been betting that authorities would intervene, so his description of the prize arrives with a position attached; Orso counts three employees and $387 million in regulatory assets, per WAD's records. If the same machinery could be applied to wages, salaries and bonuses, it would appeal to vast numbers of millionaires and take an even bigger bite out of U.S. tax collections.

The notice was one of several warnings the agency issued to Wall Street that day, treating these structures as a category rather than one firm's product.

Scale turned a technical argument into a compliance question: tax-aware long-short trading has attracted more than $150 billion in three years by some estimates, and the construction is simple—place long and short bets on stocks, exit the trades that lose money to lock in losses, and keep the profitable bets running.

In its notice the IRS acknowledged that broad stock-focused strategies may comport with "long-standing, well established techniques" for reducing taxes, suggesting the stock-picking core of these products is not where any new rule would bite; the named structures sit elsewhere—currency bets and equity swaps paired with futures—and where the line falls is the question advisors will have to answer for clients.

Daniel Hemel, a professor at New York University School of Law, sized the stakes in market terms: "The total addressable market is huge if the Treasury doesn't do anything about it," and he described the approach pushed to its end point as "carried interest on steroids," a reference to the low rates private equity executives long paid on their gains.

Monday's notice did not arrive alone. In a separate publication the agency took up so-called 351 conversions, in which investors seed exchange-traded funds that later diversify their holdings without triggering tax bills; in a ruling the agency has also moved on the technique—as we reported this week, a prearranged conversion that quickly and materially changes a portfolio can be recharacterized, leaving the holding period and the size of the shift open.

Both techniques were built to produce a tax result rather than an investment one, and both now carry agency attention in the same week—so the paperwork matters more to advisors than to the traders who run the positions.

Start with the description. An advisor with a client in a tax-aware long-short sleeve needs the manager's account of the actual trades, because a stock-focused strategy that harvests losses against gains sits on ground the agency has described as well established, while a product whose return depends on currency bets or on paired equity-swap and futures positions is the kind the notice names. Those distinctions belong in the conversation the advisor is already having with the client's CPA, and they are not visible from the sleeve's marketing name.

Then set expectations. Nothing in the notice bars any trade today; it announces an intent to publish guidance and the possibility of other steps. That matters because these products were sold on a tax result, and a rule arriving mid-holding-period can change the after-tax math on a position a client already owns; whether any guidance would reach existing positions or only new trades is not addressed in the coverage of the notice.

Do the arithmetic now. An ordinary-income strategy is worth the most to clients whose income is large and whose capital-gains planning is already handled—clients, in other words, who are already paying for advice—so the question at the next review is what the sleeve contributes after tax if the tax result has to be discounted, and what it costs to unwind if the structure is altered.

As this publication has argued, semiliquid and illiquid alternatives have moved into model portfolios, and fair value, interval fund liquidity and fee transparency are now the floor for any sleeve an advisor recommends. Tax-aware long-short trading adds a line: the advisor has to be able to say which part of a product's tax result rests on structures the IRS has said it is studying.

The guidance is the trigger to watch, and two questions follow: whether the currency bets and equity-swap-and-futures combinations are barred outright, and whether the agency aims at ordinary income specifically or at the wider array of tax-reducing tactics it flagged. In the meantime the useful work is inventory—which client holds which sleeve, and what the manager says the trades actually are.