IRS Targets Wall Street's Ultimate Tax Loophole for Ultra-Wealthy
The IRS is moving to close a massive tax loophole used by hedge funds to convert investment losses into ordinary income deductions for America's elite, threatening retroactive enforcement.
For three years, more than $150 billion flowed into a single investment strategy that promised America's ultra-wealthy the closest thing to financial magic: lowering their tax bills without sacrificing returns. Now, the Internal Revenue Service (IRS) is sending its clearest signal yet that it intends to shut down the scheme, including a warning of the kind that keeps money managers awake at night: the new guidelines may apply retroactively, even to deals already executed.
How to Generate Losses Without Really Losing
The basis is known as tax-loss harvesting, a well-known and mature practice. An investment portfolio sells declining stocks, locks in a loss for tax purposes, and buys similar exposure instead to stay in the market. The loss offsets other current, real gains and reduces the tax bill without altering the portfolio itself very much. The hedge fund twist is doing this on an industrial scale: a long-short strategy holding hundreds of positions simultaneously, some betting on an upside and some on a downturn. In such a portfolio, there are always losing positions, even in an excellent year. The fund repeatedly closes them, locks in the loss, and opens similar exposure in their place, while the winning positions continue to run without being sold and without generating a taxable event.
It is important to understand: the tax does not disappear, it is deferred. The losses reduce today's tax bill, and the gain accumulated in the portfolio will be taxed when sold in the future. But a multi-year deferral is worth a lot of money, and anyone holding the portfolio until death can bequeath it as the tax basis resets under American law, potentially wiping out the deferred tax entirely.
So far, these are capital losses, which offset capital gains only. Wall Street's holy grail is the upgrade: turning these losses into ordinary losses that also offset wages, bonuses, and stock grants. This is a huge advantage because ordinary income is taxed in the U.S. at up to 37% federally, and long-term capital gains at only about 20%. To achieve this, funds use instruments that U.S. tax codes classify as ordinary income, such as foreign currency transactions and combinations of equity swaps with futures contracts. The transactions are engineered so that the losses fall on the ordinary side of the tax code and offset a salary at 37%, while the gains fall on the side of discounted capital gains.
The fund most identified with this move is Delphi Plus by AQR, one of the world's largest hedge funds, which managed $6.6 billion mid-year. According to leaked documents, in 2025 it generated ordinary tax losses for its investors amounting to 28% of the invested capital. Simply put: anyone who put in $1 million got $280,000 of paper losses to offset against their salary, without the money actually being lost.
A Numeric Example to Clarify the Loophole
A senior Wall Street executive receives a $2 million bonus. At a 37% marginal tax rate, the tax bill on the bonus is $740,000. She invests $3 million in a Delphi Plus-style fund, which generates an ordinary loss of 28% of the capital, meaning $840,000 on paper. This loss offsets the entire bonus, and her tax bill drops to zero. The money itself barely moves: her portfolio is worth roughly the same, and the loss recorded today is expected to return in the future as a capital gain, taxed at only about 20%. In short: the trick converts a 37% tax today into a 20% tax sometime later, and the difference—hundreds of thousands of dollars in a single year—stays in her pocket.
The Regulator Moves From Talk to Action
The IRS announcement on Monday is an official escalation of warnings previously voiced only in professional conferences. The agency announced it will publish guidelines, and perhaps take further steps, to block transactions used by money managers to generate losses on ordinary income, specifically pointing to types of currency bets and combinations of equity swaps and futures. Its wording is sharp: some of these funds appear driven primarily by tax considerations rather than aiming to generate real economic returns from genuine investment activity. Treasury Secretary Scott Bessent added that the department is serious about eradicating transactions designed to evade taxes or exploit the federal tax code.
In the same announcement, the agency also targeted another popular trick: Section 351 conversions, where investors inject stock portfolios into new ETFs that diversify holdings without triggering a taxable event. Restrictions are expected there as well.
Big Money at Stake
If these techniques spread from the mega-wealthy to ordinary millionaires, it amounts to carried interest on steroids—a nod to the famous private equity tax loophole—and the potential market is massive. There are even those who bet on this exact moment: a San Francisco short fund manager built an entire position around the assumption that authorities would intervene, exactly as is happening now.
By the way, in Israel, this trick would not fly. The Income Tax Ordinance allows offsetting capital losses against capital gains, and under certain conditions against interest and dividends from securities, but not against salary. However, it does work for major capital market players. Imagine a portfolio of tens of millions that earned 10 million in a year. It can set up a put and call strategy on indices where one side of the strategy is up 15 million and the other side is down 15 million, and in a single moment buy the losing position and resell it. This locks in a massive loss while leaving a position with unrealized profit on which no tax will be paid.
This comparison illustrates how valuable the American loophole is: it bridges two tax worlds that are supposed to be separated—investments and wages—and funnels the benefit directly to the people with the highest salaries and bonuses on the market.
AQR itself remained silent this week, but has previously stated that it adjusts its strategies to operate within all relevant guidelines and regulations. The open question now is twofold: how fast the guidelines will arrive, and how far back they will apply. Meanwhile, the money managers of the top percentile are discovering that even the holy grail has an expiration date.
