The Total Return Swap on a Concentrated Position
This is the one to understand properly, because it will be pitched to you if you have an eight-figure concentrated stock position, and it sits alongside the collar and the variable prepaid forward of section “Asymmetric Tail Hedging for Concentrated Equity”.
The structure: you pay the total return of your concentrated stock to a dealer and receive the total return of something you would rather own — a broad index — plus or minus a financing spread. Economically you have diversified without selling. Nothing was disposed of, no shares moved, and no capital gain was triggered.
Except that this is exactly the transaction IRC §1259 was written to stop. IRC §1259(c)(1)(B) makes it a constructive sale to “enter into an offsetting notional principal contract with respect to the same or substantially identical property” — and a swap in which you pay away the total return of your own appreciated stock is the textbook offsetting notional principal contract. Do not let anyone sell you a total return swap that shorts your own concentrated position; it is a taxable sale by statute, and the fact that no shares moved is irrelevant. The structures that work — collars with genuine residual risk, variable prepaid forwards, exchange funds — work precisely because they leave you meaningful exposure that a constructive sale would have eliminated.
Where a TRS is legitimately useful to a private client is the other direction: gaining exposure you cannot otherwise access (a foreign market with ownership restrictions, or a basket you cannot efficiently replicate), or obtaining leverage at institutional financing spreads. Check what the reference asset is before you take that exposure. If it is a pass-through entity — a hedge fund or other partnership, a RIC, a REIT, a trust — the swap is a constructive ownership transaction under IRC §1260, “Gains from constructive ownership transactions”: any long-term gain above what you would have earned holding the entity directly is recharacterized as ordinary income, with an interest charge added as though that income had accrued each year at the federal rate. A TRS on a hedge-fund basket is precisely the transaction the section was written for; a TRS on a plain index is not. Consider the counterparties: first, you are an unsecured creditor of the dealer for any in-the-money value beyond posted collateral — Archegos taught the dealers that lesson in 2021, and the family office on the other side was wiped out in days when the collateral calls arrived. Second, the financing spread is negotiated, not publicly quoted; if you do not have the balance sheet to make a dealer compete for your business, you will pay for that.