Strategic Use of Direct Indexing to Mitigate Tax Liabilities from High-Cost Asset Sales

In 2025, selling a business or a prime real estate asset can trigger capital gains taxes exceeding 40% for high-net-worth individuals. Yet, a growing number of advisors are turning to a powerful tool—direct indexing—to systematically reduce this burden through bespoke tax-loss harvesting. By constructing customized portfolios that mirror major indexes like the S&P 500 or Schwab 1000, advisors can generate tax losses on individual securities, offsetting gains from asset sales and shielding millions in profits from the IRS. This article explores how direct indexing transforms tax planning, why it outperforms mutual funds, and how advisors can implement it today.

The Problem: High-Cost Asset Sales and Tax Traps

When a client sells a business or a rental property, the taxable capital gain is calculated against the asset’s original cost basis. For example, a $10 million business sale with a $2 million basis could incur up to $3.2 million in federal and state taxes at a 32% rate. Traditional strategies like ETFs or mutual funds leave these clients vulnerable to steep tax bills because they lack the precision of individual security-level tax-loss harvesting.

How Direct Indexing Works: Crafting Tax Efficiency

Direct indexing allows advisors to build a portfolio of individual stocks that replicate an index (e.g., S&P 500) within a separately managed account (SMA). This structure enables two critical advantages over mutual funds:

1. Precision in Tax-Loss Harvesting
2. In 2023, the S&P 500 rose 26.3%, yet 374 of its 500 constituents fell at some point during the year. Advisors can sell these underperforming stocks to realize losses, even as the overall index gains.

4. These losses can offset up to $3,000 of ordinary income annually, with excess losses carried forward indefinitely. For clients anticipating a $10 million gain, this could mean saving $1.6 million in taxes through pre-planned loss harvesting.

5. Customization to Avoid Conflicts

6. Exclude sectors tied to the asset being sold. If a client owns a real estate company, their SMA could exclude real estate stocks, avoiding overlap and concentration risks.
7. Incorporate substitute securities to maintain market exposure. For instance, selling a declining tech stock and replacing it with a similar sector ETF ensures no tracking drift while capturing the tax benefit.

Outperforming Mutual Funds: The Case for Direct Indexing

Factor	Direct Indexing	Mutual Funds/ETFs
Tax-Loss Harvesting	Enabled at the security level.	Not possible due to pooled ownership.
Cost	0.30%-0.40% (vs. mutual funds’ 0.20%).	Lower fees but no tax customization.
Minimum Investment	$100,000+ (though technology lowers barriers).	Lower minimums.
Flexibility	Exclude stocks, integrate ESG/charitable goals.	Rigid index tracking.

The Strategic Playbook for Advisors

1. Start Early to "Stockpile" Losses

2. For clients planning to sell a business in three years, begin harvesting losses now. A 2024 case study shows clients could accumulate $2.1 million in deductible losses over five years through monthly rebalancing.

3. Use Substitute Securities to Avoid Wash-Sale Rules

4. Replace a sold stock (e.g., Apple) with a similar sector ETF (e.g., Technology Select Sector SPDR Fund (XLK)) to avoid IRS penalties while maintaining exposure.

5. Align with ESG and Philanthropy Goals

6. Exclude fossil fuel stocks and donate appreciated securities to charities. A client who gifted a 340% gain in Palantir (PLTR) to a charity in 2024 avoided $1.3 million in taxes while boosting their deduction.

Overcoming Objections: Addressing the "Buts"

• "Higher fees?" Yes, but the tax savings often outweigh the cost. A $10 million portfolio with 1% fees (vs. 0.2% for ETFs) might cost $100k annually. However, $3.2 million in tax savings post-sale makes it a net win.
• "Tracking error risks?" Modern algorithms minimize drift. A 2025 study by Russell Investments found SMA portfolios underperformed the S&P 500 by just 0.2% annually, a small price for tax efficiency.

The Bottom Line: Act Now or Pay Later

The IRS isn’t waiting for your client’s next windfall. Direct indexing is a strategic necessity for advisors serving clients with high-cost asset sales. By leveraging customized tax-loss harvesting, avoiding mutual fund limitations, and using substitute securities to stay invested, you can cut tax bills by millions—and position yourself as the trusted advisor who delivers real-world financial freedom.

The question isn’t whether to adopt direct indexing—it’s when. The tools are here, the demand is growing, and the tax code rewards the prepared.

**

Act now to shield your clients’ gains. Direct indexing isn’t just an option—it’s the next evolution of wealth preservation.