Tax Planning for Losses for Hedge Funds and Individuals
The stock and crypto markets are both significantly down from the beginning of 2022. Funds and other investors may have considerable realized and unrealized losses. Tax planning may help soften the economic impact. In this alert, we focus on tax planning for funds and individuals.
The type of tax planning that may be available depends on whether the losses are business losses or capital losses. Business losses may offset ordinary income with any excess creating a net operating loss (“NOL”), whereas capital losses may only be offset against capital gains plus up to $3,000 of ordinary income in a taxable year. Under current law, NOLs can no longer be carried back to prior years, but can be carried forward indefinitely. However, NOLs may only offset 80% of taxable income when carried forward. Excess capital losses cannot be carried back, but can be carried forward as a capital loss in future years, subject to the limitation on capital losses described above.
This tax alert discusses various potential ideas for tax planning for losses.
- Harvest losses. Many taxpayers may own stocks or cryptocurrencies with unrealized losses. It may be beneficial to realize losses and then repurchase the same assets or similar assets so that they are in a similar economic position but have realized losses for tax purposes. “Harvesting” capital losses during the year – not just at year-end – can increase the amount of tax losses for a particular year. However, the “wash sale” rules disallow a loss on the sale or disposition of stock or securities if, within a period beginning 30 days before and ending 30 days after the date of the disposition, the taxpayer acquires substantially identical stock or securities. (See below regarding cryptocurrencies, however.) There are tax planning techniques to try to mitigate the limitations of, or potentially take advantage of, the wash sale rules, such as the potential use of options or doubling up or other tax planning techniques. Also, consider whether any unrealized gains and losses are short-term (holding period is not more than 1 year) or long-term (holding period is more than 1 year). Short-term capital losses are generally more valuable than long-term capital losses.
- Accelerate income into 2022. If taxpayers choose to harvest losses in a year, they may also be able to realize additional capital gains in that same year without incurring any tax liability. If you are selling a private or non-liquid investment to realize gain, it may take some time to execute a transaction. Therefore, the sales process may need to begin with enough lead time so that the gains are realized before year-end. In contrast with losses, there are no wash sale rules for gains, meaning you can generally sell something at a gain and then buy it back shortly thereafter without any suspension of the gain (but the holding period would start anew). Moreover, with the Biden Administration’s tax proposals seeking to increase U.S. federal income tax rates, accelerating income into tax year 2022 may generally be beneficial.
- Realize capital losses on cryptocurrencies since they are not subject to the wash sale rules. Because, under current law, the wash sale rules (and “constructive sale” rules) do not apply to cryptocurrencies. you could sell cryptocurrencies at a loss and buy them back shortly thereafter (there should be some period of time), without any suspension of loss under the wash sale rules. (Note, the Biden Administration’s tax proposals would subject cryptocurrencies to the wash sale rules and the constructive sale rules effective January 1, 2022, but if such proposals are enacted, at this point, it is unlikely that they would be retroactively effective.)
- Make a mark-to-market election under Section 475(f)? Too late generally for 2022 but possibly not for very new taxpayers. A 475(f) mark-to-market election for a trader in securities needs to be made by the due date, without extension, of the tax return for the prior year (i.e., for a calendar year hedge fund that existed in 2021, the election had to be made by March 15, 2022, and for individuals the election had to be made by April 15, 2022). Accordingly, it is generally too late to make the election for 2022. (Click here for our tax alert regarding Section 475(f) mark-to-market elections.) However, the election may still be available for certain newly formed entities. For example, a partnership that started on May 1, 2022, could make the election by July 15, 2022. A mark-to-market election would cause any gains and losses to be treated as ordinary and realized as if the stocks or securities (or commodities if an election is made therefor) were sold for fair market value at the end of every taxable year. This would generally convert a capital loss that is subject to limitation to an ordinary loss that may be used against other income.
- Affirmatively use the excess business loss rules. Individuals are subject to the excess business loss rules (the “EBL rules”). The EBL rules provide that business losses in excess of a certain threshold cannot be applied against non-business income (such as investment income from a fund that is an investor and not a trader for tax purposes) and any excess above the threshold is carried forward as an NOL to the following year. The ability to convert an EBL and use it as an NOL in the following years would generally be more beneficial. Therefore, it may be possible to realize losses in 2022 to potentially increase your NOL that is carried forward to 2023, thus taking advantage of the EBL rules. Legislation proposed in 2021 would change the characterization of unused EBLs so that they would remain subject to the EBL rules in following years.
- Carry back Section 1256 losses. Section 1256 requires that certain options, futures and forward contracts be accounted for on a mark-to-market basis; that is, treated as if they were sold for fair market value at the end of every taxable year. Gain or loss with respect to Section 1256 contracts is 40% short-term and 60% long-term capital gain or loss, regardless of actual holding period, with certain exceptions for foreign-currency-related investments. If a taxpayer has a net Section 1256 loss for the taxable year, the taxpayer can carry the loss back three years and apply it against net Section 1256 gains in such prior years. This is one of the few situations where losses can be carried back, albeit only against net Section 1256 gains. A taxpayer with net Section 1256 gain in 2019, 2020 or 2021, and a current year Section 1256 loss should consider electing with their 2022 tax return to carry back such net loss. It may also be possible to use the wash sales rules to convert non-Section 1256 losses to Section 1256 losses in order to be able utilize this benefit.
- What if you made a lot of money in 2021 but are sitting on losses in 2022? Unfortunately, due to market swings, a number of people have found that they made significant money in 2021 (and owed significant taxes for 2021) but have incurred considerable losses in 2022. There are very limited tax planning options to remedy this, especially now that NOLs can no longer be carried back. One idea, discussed above, is the ability to potentially be able to carry back Section 1256 losses. Another idea may be if there is a way to defer gains realized in 2021 until 2022 or later years and offset the gains with losses incurred in 2022.
- Take a worthless stock or bad debt deduction. In some situations, taxpayers may find that they are unable to sell or otherwise dispose of stocks in their investment portfolio, perhaps due to the stocks having very little to no value. Similar issues may arise with respect to cryptocurrency, such as in the recent Terra Firma collapse. A taxpayer may generally deduct the cost basis of stock in the year it becomes completely worthless. Abandonment may be another way to realize losses if the market for the asset has ceased or it is not feasible to sell. Losses that are generated from worthless securities are generally capital losses. Also, taxpayers who have made loans in either business or nonbusiness settings should consider whether the downturn and its economic impact will limit the ability of the debtor to repay the loan. If a taxpayer makes a loan and determines that the loan has become completely worthless, the taxpayer may be able to take a bad debt deduction. Worthlessness is a complex, fact-based determination, but a debt generally becomes worthless when there is no longer any possibility that the amount owed will be repaid. Business bad debts give rise to ordinary losses, while nonbusiness bad debts give rise to short-term capital losses.
- Marry someone with gains…(This one is in jest, but works.) This idea came up while we were working with an accountant when the stock market cratered in 1998 due to the Long-Term Capital Management crisis. A mutual client who was single had suffered significant losses in the market and it was a very novel, funny and creative idea to utilize the losses. And no, the client did not use it.
We note that the above list of ideas is not exclusive and there may be other ideas or issues to consider that have not been discussed in this alert. Wash sale rules, straddle rules and other tax issues, including state tax issues, can be very complex. Taxpayers should consult their tax advisors regarding the possible implications of any of the ideas discussed in this alert and their tax consequences based on their particular facts and circumstances.
If you have any questions regarding tax planning for losses or any other tax planning ideas or issues, please contact your primary Kleinberg Kaplan attorney or one of the members of our Tax Department.