Would you rather sell a $1M asset, pay 35% in federal and state capital gains tax, and invest the remaining $650k in a diversified portfolio?
Or would you rather sell the same asset and invest the full $1M into a diversified portfolio from day one — deferring the capital gains tax until a future date, and with the right planning, eliminating that liability entirely?
One of the most powerful financial planning strategies I have come across is called tax-aware investing. It lets you defer a current tax liability and, over time, eliminate it — without sacrificing long-term market exposure, liquidity, or your heirs’ tax-free step-up in basis.
What Tax-Aware Investing Accomplishes
At its core, tax-aware investing separates a portfolio into its winning and losing positions, harvests the losses to offset current gains, and keeps the winners invested so they can compound — and eventually pass to heirs tax-free. Combined with leverage, it also amplifies both the deductible losses and the long-term return. Here is what a well-executed strategy achieves:
• Tax deferral: Offset a large one-time capital gain (e.g., sale of a business, concentrated stock position, or home) with short-term portfolio losses, pushing the tax owed into the future.
• Tax elimination: Hold deferred gains until death, at which point heirs receive a stepped-up basis and inherit the position entirely tax-free.
• Amplified deductions through leverage: Borrow against the portfolio to increase both deductible losses and unrealized gains, while paying tax-deductible interest.
• Pre-tax alpha from long/short extensions: Go long on portfolio winners and short the losers, earning additional return using borrowed — not personal — capital.
Let’s walk through the math.
Step 1: The Value of Deferring Taxes
Suppose it’s January 1st and you just sold a business or stock for $1 million, owing $350,000 in tax by year-end. You have two basic options:
• Reserve $343k now to cover the tax bill and invest the remaining $657k.
• Invest the full $1M immediately and pay the $350k at year-end.
The second option beats the first (see Table 1 below), but only by about 2% after one year. For deferral to be truly meaningful, you need one or both of the following:
1. Defer for many years so the compounding advantage grows over time.
2. Lower your terminal tax rate, arbitraging the gap between your higher rate today and a lower rate in the future.
Step 2: From Deferral to Elimination — Step-Up in Basis
The single most powerful tool for turning deferral into elimination is the step-up in basis. When you sell an appreciated asset during your lifetime, you pay tax on the gain. But if you pass the asset to your heirs at death, the basis resets to the current market value — and they can sell it immediately with zero taxable gain.
In the example below, when the same asset is passed on to the next generation the basis is stepped up from $1,000 to $10,000 which eliminates the taxable gain. So the heirs can sell the asset at that time without paying taxes.
This is the second leg of the strategy: hold the deferred gains until death, let the step-up in basis reset the tax clock, and pass the entire position to your heirs tax-free.
Step 3: Combining Deferral and Elimination
When you layer step-up in basis on top of tax-deferral, the results are dramatic. The table below compares all three approaches for a $1M starting position:
The combination of deferral and future tax elimination is the foundation of generational wealth building for long-term portfolio positions. Tax-aware investing takes this a step further by dramatically increasing the amount you can defer in the first place.
Tax-aware investing allows me the ability to invest the full $1M today knowing that the $1M portfolio will generate losses in parts of the portfolio to offset my current tax-liability and defer it until later.
That way I get to invest the full $1M today—and eliminate the tax-liability in the future
Tax-Aware Investing: Using Portfolio Losses to Offset Gains
Most investors assume that when the stock market returns 10% in a year, all their stocks go up by 10%. In reality, only a small fraction of stocks drive virtually all net market gains. A well-known study by an Arizona State professor found that only 4% of stocks have generated the entire net gain of the stock market — and the median compound annual return of individual stocks was −6.9%.
This dispersion is a feature, not a bug. Because so many stocks generate losses in any given year, we can harvest those losses to offset gains elsewhere in the portfolio — all while staying invested in the same market.
A Simple Illustration
Imagine a stock market with just two equally-weighted stocks: one earning +15% and the other losing −5%. The portfolio’s net return is still 10% — identical to owning a single index fund.
But in the two-stock version, I can realize the $50k loss by selling the loser and defer the $150k gain by holding the winner. If that $50k loss offsets $50k of capital gains from a business sale, my net tax for the year is zero.
You might object: “You’re just deferring more taxes, not eliminating them.” That’s true in isolation. But as a long-term investor who intends to hold equities until death, the deferred gain is never realized — it is eliminated through step-up in basis when my heirs inherit the position.
So in the initial example where a client sold an asset with a $1M taxable gain, tax-aware investing allows them to immediately invest that $1M and use the losses generated by the new diversified portfolio to offset the initial taxable gain—thereby creating a large deferred unrealized gain in future years.
How Does Leverage Play Into This?
In a previous post, I described the value of portfolio leverage — not just as a return-booster, but as a financial planning tool. By borrowing against a portfolio at low rates (currently around 4%–4.5%), you get liquidity without triggering a taxable event, and the interest is tax-deductible.
Tax-aware investing takes this further: leverage amplifies both the deductible losses and the unrealized gains, making the entire strategy more powerful.
The Math of Levering Up
Take the same $1M two-stock portfolio earning a net 10%. Now borrow an additional $1M against it, bringing total invested assets to $2M at a 50% loan-to-value ratio. The cost of borrowing is 4.5%.
With leverage, harvestable losses nearly triple — from $50k to $145k (combining the doubled stock losses and the $45k interest deduction). Meanwhile, unrealized gains double to $300k.
The key condition: the portfolio’s long-term return (10%) must exceed the cost of borrowing (4.5%). As long as that spread holds, leverage increases net wealth while simultaneously generating more tax deductions.
The appropriate level of leverage depends on three factors:
1. How large is the capital gain liability you need to offset?
2. How much pre-tax alpha do you expect from the strategy?
3. How much conviction do you have in the manager’s stock-selection ability?
Creating Pre-Tax Alpha with Long/Short Extensions
The strategy becomes even more compelling when we add a long/short overlay — buying (going “long”) the expected winners and selling (going “short”) the expected losers.
How a Short Position Works
When you short a stock, you borrow it today, sell it immediately for cash, and agree to return it at a future date. If the stock falls as expected, you buy it back cheaper and pocket the difference.
In our example: short the “losing” stock (expected to fall 5%) today for $1M in cash. Use that $1M to buy the “winning” stock (expected to rise 15%). At year-end:
• Sell the winning stock for $1.15M.
• Buy back the losing stock for $950k and return it to the lender.
• Pay $45k in borrowing costs.
• Net profit: $20k — entirely using borrowed capital.
Comparing Own Capital vs. Leveraged Long/Short
The $20k profit from the long/short trade is smaller in absolute terms than the $100k you’d earn by investing $1M of your own money in an index. But the critical difference: the long/short trade required zero personal capital.
In practice, long/short positions are extensions of the underlying tax-aware strategy — not a replacement for it. You still invest your own capital in a diversified equity portfolio. The long/short overlay sits on top, generating additional losses and return using the portfolio as collateral.
One Important Tax Nuance
The long/short positions create realized short-term gains rather than unrealized long-term gains. These would be taxable unless offset by sufficient deductible losses from the leverage. In the example above, borrowing $1.4M (instead of $1M) would generate enough interest deductions (∼$63k) to fully neutralize the $20k short-term gain.
Conclusion
Tax-aware investing converts a large, concentrated capital gains liability into a long-term, diversified equity position — while deferring the tax indefinitely and ultimately eliminating it through step-up in basis at death.
Leverage makes the strategy more powerful on two fronts: it increases the size of current tax deductions, and it creates the opportunity for pre-tax alpha from the spread between borrowing costs and market returns. The interest on portfolio loans is tax-deductible, the gains compound untaxed, and heirs inherit the entire position tax-free.
For clients with a large taxable event on the horizon — a business sale, a concentrated stock position, or a real estate transaction — this strategy can mean the difference between sending a third of the gain to the IRS today or keeping the entire amount working for the family for decades.
Need Help With a Large Capital Gains Liability?
Do you have a concentrated stock position or an impending capital gains tax liability from the sale of a home or business? We can help you evaluate strategies like the ones described above.
Book a call with us at colva.youcanbook.me.
About the Author
Rajiv Rebello helps HNW clients implement better after-tax, risk-adjusted wealth and estate solutions through strategic planning and life insurance and annuity vehicles. He can be reached at rajiv.rebello@colvacapital.com.