How to create a financial product that top billionaires and tech elites find hard to resist? Smart Wall Street fund managers are using legal rules to promote this lucrative commission-based business.

The secret behind it is simple - playing around with capital gains tax. Unlike stock investors in the A-share market, many countries tax the money earned by stock investors, and the rules are quite complex. Taking the U.S. stock market as an example, when holding stocks for over a year, the highest tax rate upon selling is 20%. Short-term gains are subject to ordinary income tax rates, which can go up to 37%.

Therefore, it's not hard to understand why some American investors realize unrealized losses in their holdings before filing taxes, offsetting some profits. But the limitation of this operation is that with the long bullish trend in the U.S. stock market, stockholders looking to cash out may not easily find investments with unrealized losses.

This is the moment when Wall Street salespeople come knocking on the door.

U.S. stock market in a long bull run without having to pay capital gains tax?

Suppose you are an American engineer who has worked at Apple for several years, accumulating $1 million worth of company stocks. Faced with the U.S. election, you feel uneasy about concentrating your wealth in a single stock and want to sell these stocks to buy S&P 500 index funds.

If you were to sell directly, you would need to pay hundreds of thousands of dollars in taxes. But now you also have another option: Establish a 'tax-sensitive long-short strategy' position.

Before selling Apple stocks, you need to use the $1 million stocks as collateral to establish a combination of long and short positions, achieved through margin trading and short selling, without using derivatives. Typically, this investment portfolio consists of 130% long positions and 30% short positions, and the percentage of short positions can be increased further if aiming for "faster losses".

This type of investment portfolio usually includes hundreds of symbols, allowing for the identification of securities in unrealized losses that can be sold to generate investment losses. The proceeds from the sales are then used to repurchase similar securities to maintain the balance of the entire investment portfolio. The losses themselves can be used to offset capital gains elsewhere. Therefore, Apple engineers can gradually sell off their Apple stocks while utilizing the generated losses to minimize tax liabilities.

While the example only used stocks, in reality, selling property or realizing capital gains from businesses can also be "offset" in this manner.

Of course, the money lost here is not actual losses because the other side of the long-short strategy is profitable, and the United States currently does not tax "unrealized gains." This rule is also the foundation of the entire business.

Facing the continuous surge of the U.S. stock market to new historical highs, coupled with the artificial intelligence boom creating a large number of new technology giants, this strategy is growing at an astonishing speed. By the end of September, the pioneer of this approach - AQR Capital Management's tax-managed long-short strategy assets doubled to $9.9 billion in six months. Quantinno, established in 2021 and deeply cultivating this path, also saw its AUM reach $7 billion.

Morgan Stanley has also indicated that they will soon launch similar services, while established asset management giants like Blackstone and Invesco have also entered the game.

In a time when operating index funds can hardly receive management fees, this tax strategy has brought greater revenue potential to fund companies - these strategy funds typically charge a 50 basis points management fee, in addition to a 30 basis points financing fee, totaling almost twice that of index funds.

According to research firm Cerulli Associates' report, this tax-managed long-short strategy has been present on Wall Street for decades, but with technology making strategies easier to handle, the barrier to entry has lowered. The firm predicts that this will rapidly develop into a $3 trillion industry.

That being said, this strategy's complexity still requires a certain level of capital from investors, typically starting with a "seven-figure" net worth. The more assets one has, the more profit they can obtain from it.

Eddie Bernhardt, head of Invesco's Separately Managed Accounts (SMAs) business, stated that growth-oriented technology and AI companies are currently generating a significant amount of wealth, with individuals eager to capitalize on this wealth. Asset management personnel are "circling the parking lot," waiting for engineers to come out so they can hand out their business cards.

This is also an issue of fairness.

Smart investors can easily see that the purpose of this trickery is to artificially delay the payment of capital gains tax that should have been paid, which will eventually need to be settled. However, this also brings about a social problem: the effective tax rate paid by the wealthy class is lower than that of the working class.

Moreover, overall, US stock investors should also benefit from longer-term investments by indirectly "keeping the money in their own pockets" that should have been paid in taxes. Ideally, they would only fully exit this investment upon retirement or moving to areas with lower tax rates. For ultra-wealthy individuals, there are further ways to avoid taxes such as setting up charitable foundations.

University of California, Berkeley law and economics professor Alan Auerbach pointed out that the current realization-based tax system has always had issues. A considerable portion of capital gains will never be realized, either through investors continuously postponing the sale or cleverly utilizing charitable donations. When they pass away and pass on assets to heirs, the capital gains reset.

Auerbach lamented, "Money has a time value, even if it's just a delay. If we're talking about a year or two, it's not a big deal, but if it's 50 years, it's a big deal."

In the face of the concept of taxing unrealized capital gains, the Biden administration had previously proposed it, but his successor Harris refused to provide a clear vision. She had indicated a new tax on the wealthiest Americans, but declined to clarify whether it would cover unrealized capital gains.

Conversely, as long as this rule is not violated, any behavior of taxing wealthy investors will exacerbate the prosperity of tax arbitrage strategies. From a legal perspective, this practice is completely legal as long as it does not violate certain restrictions, such as buying back highly similar securities within 30 days of selling, or placing both call and put bets on the same security simultaneously.

Columbia Law School professor David Schizer stated that this business model involves 'spending an excessive amount of time and energy pursuing lower tax rates', which should not be encouraged from a systemic perspective.

From the perspective of the US government, capital gains tax is also a significant source of income. According to the analysis of the Congressional Budget Office, in 2021 (before the current bull market in US stocks started), capital gains reached the highest level in 40 years as a percentage of the economy. For the top 1% of taxpayers, capital gains accounted for 39% of their income that year.

Editor/rice