Investors with significant unrealized gains in a single stock often face a familiar dilemma: reduce risk through diversification and incur a capital gains tax, or maintain exposure and accept the concentration risk. This decision is particularly relevant for individuals holding low cost-basis stock acquired through compensation, inheritance, or after a liquidity event. 

A structured, tax-aware investment approach may offer a potential solution. We believe a particular example of this approach is long/short equity overlays, which allow investors to maintain broad market exposure while gradually managing concentrated positions and generating tax-loss harvesting opportunities, potentially without requiring an immediate sale of appreciated assets. 

This article explores how this type of strategy works and how it may help address the specific needs of investors with embedded capital gains. 

The Challenge: Balancing Exposure, Risk, and Taxes 

Investors with concentrated equity positions often aim to: 

• Remain invested in equity markets, preserving participation in long-term growth. 

• Mitigate concentration risk, which can create portfolio volatility or limit diversification. 

• Minimize realized capital gains taxes by avoiding large one-time sales. 

• Manage liquidity and cash flow needs over a multi-year horizon. 

Common tools like traditional direct indexing or exchange funds offer ways to manage these goals, but they may involve trade-offs. Direct indexing typically requires the appreciated stock to be sold in part or in whole to fund the strategy. Exchange funds may involve pooled risk and long lockup periods. Traditional tax-loss harvesting opportunities, meanwhile, tend to rely on market volatility and may be less consistent in delivering tax losses over time with rising market environments. ¹ 

A Potential Alternative: Long/Short Equity Overlay Strategies 

A tax-aware long/short overlay is a market-neutral extension layered on top of an investor’s existing public equity holdings. The investor typically contributes appreciated securities into a separately managed account, where those assets can be used as collateral to fund an actively managed long/short portfolio. ³ 

Rather than replacing or liquidating the appreciated stock, the overlay exists alongside the investor’s core exposure. The goal is to harvest capital losses on a systematic basis by using both long and short positions across varying market conditions. 

Key structural features may include: 

• Use of collateral rather than liquidating core holdings, which can defer taxable events. 

• Harvesting losses from both long and short positions may be useful in a variety of market environments. ³ 

• Custom benchmark tracking, where the overlay portfolio can be designed to approximate a chosen index. 

• Flexible implementation, which can accommodate various risk levels, tracking error parameters, and liquidity needs. ⁴ 

Managing a Concentrated Position Over Time 

For investors with low cost basis stock, this structure may be implemented in parallel with a gradual sell-down plan. Within the long/short account, appreciated positions can potentially be sold incrementally over time. This phased approach allows investors to better manage the timing and recognition of gains, possibly aligning them with offsetting losses generated by the overlay strategy. 

Importantly, this approach does not guarantee tax savings or improved returns. The ability to harvest losses and defer gains depends on portfolio construction, market behavior, and IRS compliance rules (including wash-sale limitations). ² All strategies should be reviewed with tax professionals and legal counsel to assess suitability for individual circumstances. 

Risks for Consideration 

Before incorporating a long/short overlay, investors should weigh potential risks 

1. Equity risk: These strategies provide broad exposure to public equity markets. Equity markets can be volatile and subject to sudden fluctuations in value. Such fluctuations, often driven by macroeconomic factors like recessions, interest rate changes, and inflation, can result in significant losses.  

2. Tracking Error risk: These strategies make active investment decisions, which may result in significant deviations from a target benchmark. There is no guarantee that the manager will be successful in security selection and the manager may deliver significant pre-tax under-performance versus their benchmark.     

3. Use of Leverage: These strategies utilize varying and significant degrees of leverage, which incurs variable borrowing costs, may increase volatility of returns and the severity of any losses, and may require additional outside collateral in the event of a severe market downturn (referred to as a “margin call”).  

4. Use of shorting: These strategies will actively short equity securities, which carries both investment risk and additional expenses. Short securities may be subject to a “short squeeze”, which could result in significant losses in that security over a short period of time. Shorting securities involves borrowing costs and expenses which can be variable over time.    

5. Tax Risk: It may not be possible to defer capital gains indefinitely, to the extent there is a significant liquidity or rebalancing need from the portfolio. No amount of capital loss generation is guaranteed, and it may not be possible to fully offset other capital gains using this strategy, if those gains are sufficiently large and/or there is inadequate time to generate offsetting capital losses in a calendar year. IEQ Capital, LLC does not provide tax or legal advice. You are strongly encouraged to consult with qualified tax and/or legal counsel to evaluate the potential tax implications associated with this strategy. 

Conclusion 

If you are sitting on a large, low-cost-basis equity position and wondering how to reduce exposure without facing an outsized tax bill, it may be time to move beyond traditional approaches. Tax-aware long/short overlays offer an innovative alternative: one that combines the benefits of diversification, liquidity control, and systematic tax management. 

As always, implementation details matter. Investors should work with experienced advisors, tax professionals, and portfolio managers to structure the solution appropriately. 

At IEQ Capital, we help clients evaluate and implement tax-smart investment strategies tailored to their unique situations, including advanced overlays designed to improve after-tax outcomes while maintaining alignment with long-term financial goals. 

We invite you to connect with our investment team to explore how tax-aware strategies, including long/short overlays, may complement your existing portfolio and support more consistent, long-term tax management.   

Sources 

1. Internal Revenue Code, Section 1211 – Limitations on capital losses. 

2. IRS Publication 550 – Investment Income and Expenses. 

Disclosures 

Equities 

• Interest Rate Risk: Higher interest rates may adversely impact equity valuations. 

• Macro Risk: Macro factors including interest rates, inflation, or economic growth may lead to materially different return outcomes for the sector, particularly if there is a material impact to earnings outlooks. 

• Mark to Market Risk: Equities are relatively volatile securities and may be especially volatile in a poor macro backdrop. 

This document is for informational purposes only and is intended exclusively for the use of the persons to whom it is delivered and the information provided therein is confidential and may not be reproduced in its entirety or in part, or redistributed to any party in any form, without the prior written consent of IEQ Capital, LLC (“IEQ” or “IEQ Capital”). Information contained in this document is current only as of the date specified in the document, regardless of the time of delivery or of any investment, and IEQ does not undertake any duty to update the information set forth herein. The information contained in this document does not constitute an offer to sell or the solicitation of an offer to purchase or sell any securities, including any securities or alternative investments recommended by IEQ. Regarding alternative investments, any such offer or solicitation may be made only by means of the delivery of a confidential private offering memorandum which will contain material information not included herein regarding, among other things, information with respect to risks and potential conflicts of interest. No representation is made that any client will or is likely to achieve its objectives, that IEQ Capital’s strategies, investment process or risk management will be successful, or that any client will or is likely to achieve results comparable to any shown or will make any profit or will not suffer losses or loss of principal. Investing involves risks. You should not construe the contents of this document as legal, tax, investment or other advice. Any tax-related decisions should be made after conducting such investigations as the investor deems necessary and consulting the investor’s own legal, accounting and tax advisers to make an independent determination of the suitability and consequences of a composite election.