This Hedge Fund's $6.8 Billion Tax Break Is Going to Enrage You

If you invest or do any stock trading outside of a 401(k) or IRA account, you know that how long you hold your stocks can make a big difference at tax time.

If you buy and then hold an investment for at least a year, your profits will be taxed at the long-term capital gains rate -- 15% for people in most tax brackets and 20% for those in the very top one. Fast in-and-out trades, on the other hand, face a much bigger tax bite because they are taxed as ordinary income. What's more, you can be hit with those higher rates even if you aren't a day trader: For example, if you own an aggressively managed mutual fund that does a lot of trading, you may get capital gains distributions you have to pay tax on.

Now it appears that some high-powered hedge funds found a clever way around those higher rates, basically by turning short-term trading gains—often really short-term, as in minutes—into long-term ones. According to a report issued this week by a the Senate subcommittee on investigations, that move might have netted one fund managed by Renaissance Technologies a tax saving of $6.8 billion over several years. That billion with a B.

By what magic does a trade of a minutes become a long-term, buy-and-hold investment eligible for lower taxes? Well, it appears you just had to find a bank that will wrap your trading into something called a " basket option."

Here's how it worked: Instead of buying and selling the stocks directly, hedge funds would go to a bank—the Senate report singled out Barclays and Deutsche Bank—and buy an options contract linked to the value of a basket of securities. Think of the basket of securities as being like a stock fund; and just like a stock fund you might have in your 401(k), the composition of that basket is constantly changing. In the Renaissance case, the basket changed based on computer algorithms looking for tiny inefficiencies in asset prices, which meant constant buying and selling.

At some future date, the hedge fund could exercise the option and get back the amount it paid for the option plus or minus any returns on investments in the basket. And here's where the tax break happened: If the hedge fund waited at least year to exercise the option, all those quick in-an-out trades inside the basket got wrapped up in one big long-term trade.

The really clever (or, some might say, devious) part is that the basket of securities was all along actually still managed by the hedge fund. Technically, the banks hired Renaissance managers to run the basket backing the options that they sold to Renaissance. Did you catch that?

In Senate testimony this week, execs from the banks and Renaissance offered their side. They say that while it's true there were tax advantages to this set-up, it wasn't only a tax shelter. For example, in addition to changing the tax treatment, using an options contract also gave Renaissance a lot of leverage, since they only put in part of the money to buy the basket. That amplified their wins as well as losses. (The Senate's not too happy about that part, either, though. Since 2008, big investors using borrowed money looks more like a bug than a feature.) It also limited Renaissance's exposure to catastrophic losses, since they couldn't lose more than they paid for the option, giving the banks some skin in the game on the portfolios. In tax law, something that works like a tax shelter can still be okay if it has another economic purpose.

The Internal Revenue Service, though, indicated in 2010 that moves like this don't pass the smell test.

Howard Gleckman of the Tax Policy Center explains here why it is that the IRS might not yet have clamped down on this particular maneuver. Short answer: It's tough for the IRS to go after big hedge funds and their investors. They are outgunned. Gleckman wonders if we have a "two-tiered" tax system, one for the rich and another for the rest of us.

At the subcommittee hearing, there were really two arguments in play. One was whether the tax law technically allows quick trades to be turned into long-term investments in this way.

The other was whether it should. That doesn't seem like a hard question.