What is Tax Alpha

Tax Alpha is the increase, in percentage terms, of the size of a portfolio by not having to pay capital gain tax. Exactly how it is calculated might not be very important. What important is the definition, meaning how do we increase the portfolio by selling lost position securities to avoid paying capital gain tax in other positions.

For example, the following portfolio consists of

1)      $9000 security A (purchased at $10000)

2)      $5000 security B (purchased at $4000)

3)      $1000 cash

Now, the portfolio total value is $1000+$5000+$9000 = $15000

Assume it is planned to sell security B, because we know it is overvalued, so to realize the gain. As a result, we have to pay $1000 * 15% = $150 capital gain tax.

The final portfolio will be:

1)      $9000 security A (purchased at $10000)

2)      $1000 + $5000 – $150 = $5850

If we know that security A is actually having a grim future. We might want to sell security A also. This will generate a loss of $1000. But this can used to offset the gain from security B, and so we don’t have to pay capital gain tax! That means the portfolio has $150 higher in value. This is the tax alpha.

The portfolio will be:

$1000 + $9000 + $5000 = $15000 which is $150 higher where security A not sold.