The IRS wants to know why the losses are ordinary and the gains are capital.

The IRS wants to know why the losses are ordinary and the gains are capital.

That is what is behind this week’s headlines about AQR’s Delphi Plus fund that Bloomberg connects to strategies discussed in Notice 2026-62 (which does not mention AQR by name).

Economically, these types of funds produce a normal investment return. The tax side is where it gets interesting. The gains mostly flow through as capital gains and the losses as ordinary losses. This results from several strategies:

1. Terminating Winners and Hold the Losers. Holding a swap contract through termination - receiving only scheduled payments - is generally ordinary gain (loss). But - if you sell prior to termination, gain or loss is capital. A fund could effectively choose its tax treatment.

The IRS questions whether the supposed termination proceeds actually substitute for the scheduled ordinary payment. If they are not scheduled payments, the payments may generate capital losses.

2. Choosing Capital Gain After Winners Established. Here, the fund opens and closes currency forwards on the same day, then elects capital treatment for winners while leaving losers ordinary.

Section 988 generally makes covered foreign-currency gains and losses ordinary, but permits capital treatment for eligible contracts that are capital assets and are not part of a straddle, if an election is made and asset identified.

Here, a fund subject to the Notice is taking advantage of a statutory rule that the IRS does not like. They seem to be arguing that because the taxpayer is achieving a good result, it is contrary to the intent of the statute. This argument seems weaker.

One example involves swaps, contracts whose payments depend on an underlying asset or index. The fund closes winning swaps shortly before scheduled payments and claims capital gain. It holds losing swaps through scheduled payments and claims ordinary expense.

Here is my view.

These strategies have been widely adopted. I doubt the IRS will go back and broadly assess retail investors who took losses through large institutions. I think a more likely outcome is targeted guidance that tightens particular arrangements.

If the IRS takes that approach, the managers will have to change the way they do things. How they get there, we’ll see.

I read this as an attack on the systematic selection of ordinary losses and capital gains, where the amount of investment risk (independent of tax risk) is not clear. Taking investment risk and making money does not mean someone has done something wrong.

I think they’ll try to hone in on specific types of abuses. Future arrangements will probably have more risk associated with them, more risk of economic loss at least.

For now, I would treat diligence these arrangements pretty close moving forward as tax law evolves - and you probably should too.

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