White paper: Charitable giving with direct indexing and donor-advised funds

This paper compares two ways to give the same amount to charity: donating cash, or donating appreciated lots from a direct indexing portfolio to a donor-advised fund (DAF) and adding the cash to the portfolio instead.

Direct indexing gives investors index-like returns while harvesting tax losses. If markets rise over time, a direct indexing portfolio may build up positions that have grown in value, as can any long-term stock investment. For investors who give to charity, donating those appreciated positions may offer tax advantages compared to giving cash, depending on their circumstances.

The analysis below shows how donating the most appreciated lots to a DAF adds to the tax benefits of direct indexing, in both long-only and Long short portfolios. For lots held more than one year, investors can generally deduct the fair market value of the donation and do not owe capital gains tax on the appreciation, while giving the portfolio new room to keep harvesting losses.

Key takeaway: For charitably inclined investors who itemize, donating appreciated long-term lots from a direct indexing portfolio to a DAF may add extra tax alpha beyond what the strategy itself provides. In Frec’s hypothetical simulations, an investor with $1 million in a 250/150 S&P 500 portfolio who gave $50,000 a year generated about 0.41% a year of extra tax alpha on average, from the additional losses the portfolio harvested. Over the same period, the donation also transferred about $343,000 of unrealized gains out of the portfolio without those gains being realized. A single donation can also have a meaningful effect: an investor who donates $500,000 of stock held more than one year with a $100,000 cost basis would not owe capital gains tax on the $400,000 gain. Selling the stock and donating the cash instead could result in about $95,200 in federal capital gains tax (assuming a 23.8% rate).

Overview of donor-advised funds

A donor-advised fund is a charitable giving account maintained by a sponsoring public charity. A donor makes an irrevocable contribution of cash or securities and may be eligible for a tax deduction in the year of the donation.¹ The donor can then recommend grants to qualified charities over time, though the sponsoring organization has final approval. While assets remain in the DAF, they can be invested in options the sponsor offers, and any growth is tax-free and available for future grants. DAFs generally charge administrative and investment fees.

A potential key advantage of donating appreciated securities held more than one year is that the donor can generally deduct their full fair market value and does not owe capital gain tax on the appreciation. The main federal rules (for tax years starting 2026) are:

Rule	Appreciated stock held more than 1 year	Stock held 1 year or less	Cash
Deduction amount	Fair market value	Low of cost basis or fair market value	Amount given
Capital gains tax	None owed by donor	None owed by donor,	N/A (gain is taxed if stock is sold to raise the cash)
Annual deduction limit	30% of AGI	50% of AGI	60% of AGI
Carryforward of unused deduction	Up to 5 years	Up to 5 years	Up to 5 years

Considerations

• Donations are irrevocable. Once assets are in a DAF, the donor can’t take them back. Grants can only go to qualified charities.
• AGI limits. Deductions for appreciated stock are capped at 30% of AGI each year. Any excess carries forward for five years, which delays part of the tax benefit.
• Holding period. Only lots held more than one year are deducted at market value. In long short portfolios, straddle rules on offsetting long and short positions can suspend holding periods, so confirm each lot’s status before donation.
• Value of the donated gains. The benefit depends on the investor’s tax rates, state taxes and how much they already have in harvested losses.

Why appreciated lots build up in direct indexing

Direct indexing holds the individual stocks of an index, so losses can be harvested lot by lot. When a stock falls below its cost, the lot may be sold at a loss and replaced, while lots that rise in value are generally kept. A long short portfolio does the same, and can also generate losses on short positions that rise. If markets rise over time, more of the portfolio’s lots may be worth more than they cost. Holding appreciated lots is a normal result of a portfolio that has grown in value, and it doesn’t mean the strategy has stopped harvesting losses.

Appreciated positions are a normal part of any long-term investment, whether it holds individual stocks, ETFs or mutual funds. For charitable investors, appreciated lots in a direct indexing portfolio may offer additional benefits:

• More potential to harvest losses. Reinvesting the cash that would otherwise have been donated adds new lots at today’s prices. If prices later fall, those lots may create new loss harvesting opportunities.
• More flexibility to change course. Donating the most appreciated lots may reduce the gains realized later when rebalancing, changing benchmarks or diversifying.
• Harvested losses may go further. Donated gains are not taxed to the donor, so more of the losses the strategy harvests may be available to offset gains elsewhere, such as from a business sale or a concentrated stock position.

Lots held more than one year with the largest gains are generally the strongest candidates to donate.

Mechanics of donating through a direct index

The process has three steps: the investor adds new cash to the portfolio, donates the most appreciated lots to a DAF, and runs a full portfolio rebalance. Frec supports these steps as a single workflow. Because the new cash buys lots at current prices, it may raise the portfolio’s overall cost basis and create more future loss harvesting opportunities. This may be most useful for long-only and long short portfolios with few remaining losses to harvest.

Note that not every position is a good candidate for donating:

• Lots held more than one year: generally the strongest candidates, since they’re generally deducted at fair market value
• Lots held one year or less: deduction is generally limited to cost basis, so these are usually less tax-efficient to donate
• Short positions (long short only): cannot be donated; they must be covered with cash or long lots
• Lots with losses: donating them generally means giving up the loss. Selling them and harvesting the loss is generally more tax-efficient.

Simulations

To evaluate this approach, we ran simulations comparing two ways of giving the same amount each year: donating appreciated lots from the portfolio and adding equal amounts of cash into it, or donating cash directly while leaving the portfolio unchanged. The simulation results in this paper were produced with the following setup:

• Portfolios and benchmark: Each simulation starts with $1,000,000 in cash invested in a portfolio of individual stocks benchmarked to the S&P 500. Three strategies were tested—long-only, 140/40 long short, and 250/150 long short.
• Time periods: Each simulation runs for 10 years. There are 39 start dates, one each quarter from April 2005 to September 2014, and results are averaged across start dates.
• Rebalancing: The portfolio is rebalanced about once a month (every 31 days).
• Donations: In the donation scenarios, the portfolio makes a donation of $10,000, $20,000 or $50,000 once a year, on the first rebalance at least seven days after each anniversary of the start date (nine donations in total). Each donation uses up to 8 long stocks. If too few lots qualify, the donation falls short of the scheduled amount.
• Replacing donated assets: The value of each donation is replaced with an equal cash contribution and the same stocks are bought back to simplify simulation.
• Measurement: Gains removed is the total unrealized gain in all donated lots at the time of each donation. Additional losses harvested is the difference in net realized short-term and long-term gains and losses between each donation scenario and the same portfolio making cash donations from outside the portfolio. It includes both additional losses realized and gains that were not realized because the appreciated lots had been donated. Tax savings on donated gains is gains removed multiplied by 23.8%, the top federal long-term rate, or 37.1% including California tax.

Results

Results are shown two ways: at federal tax rates only, and at combined federal and California rates for California residents. California taxes capital gains as ordinary income, at rates up to 13.3%, with no lower rate for long-term gains. Both use the same simulations. Only the tax rates differ:

• Federal: 23.8% on long-term gains and 40.8% on short-term gains
• Federal + California: 37.1% on long-term gains (23.8% + 13.3%) and 54.1% on short-term gains (40.8% + 13.3%)

These are top marginal rates. The analysis does not model the interaction between federal and state deductions, such as the federal cap on state and local tax deductions.

Our simulations showed that giving $50,000 a year from a $1 million S&P 500 portfolio removed $315,000 to $343,000 of gains over 10 years, depending on the strategy. That represents about $75,000 to $82,000 of federal capital gains tax, or about $117,000 to $127,000 for California residents.

Gains removed by donations and additional losses harvested, compared with cash donations:

Strategy (S&P 500)	Annual donation	Gains donated	Additional losses harvested	Extra tax alpha per year: Federal	Extra tax alpha per year: Federal + California
Long-only	$10,000	$71,000	$33,000	0.08%	0.11%
Long-only	$20,000	$136,000	$64,000	0.13%	0.18%
Long-only	$50,000	$315,000	$129,000	0.27%	0.38%
140/40	$10,000	$73,000	$20,000	0.08%	0.10%
140/40	$20,000	$142,000	$55,000	0.13%	0.17%
140/40	$50,000	$334,000	$121,000	0.32%	0.43%
250/150	$10,000	$74,000	$58,000	0.10%	0.14%
250/150	$20,000	$144,000	$135,000	0.23%	0.32%
250/150	$50,000	$343,000	$214,000	0.41%	0.55%

What the results show:

Gains removed grow with donation size. Nine donations of $10,000 removed $71,000 to $74,000 of gains, and nine donations of $50,000 removed $315,000 to $343,000. Between 71% and 83% of the value donated was unrealized gain. Smaller donations were more gain-heavy because they only used the most appreciated lots.

All three portfolios harvested more losses at every donation size. The long-only portfolio harvested $33,000 to $129,000 more in net losses, and the 250/150 portfolio $58,000 to $214,000 more. Part of this comes from not selling the donated appreciated tax lots. The rest comes from the new cash, which bought lots with a fresh cost basis that can later provide opportunities to  harvest additional losses.

The effect is largest at higher leverage. The 250/150 portfolio generated $58,000 to $214,000 more in net losses. With 250% long exposure, it holds the most long lots, which likely gives each donation and cash refresh more opportunities to create new lots that can later be harvested.

California tax raises the benefit. Tax savings on donated gains are about 56% higher than at federal rates alone, because the rate on long-term gains rises from 23.8% to 37.1%. At $50,000 a year, extra tax alpha rises from 0.27% to 0.38% a year for long-only, from 0.32% to 0.43% for 140/40 and from 0.41% to 0.55% for 250/150.

The approach may be especially valuable in high-tax states. Investors in other states with high income tax rates may see similar increases.

Conclusion

For investors who plan to give to charity and itemize deductions, donating appreciated lots from a long-only or long short direct indexing portfolio may be more tax-efficient to give than cash. Donating them to a DAF transfers embedded gains out of the portfolio without the donor owing capital gains tax, leaving the opportunity to keep harvested losses for other gains. Reinvesting the cash that would otherwise have been donated may also create future loss harvesting opportunities.

That said, the approach comes with the trade-offs covered in the Overview, including irrevocable donations, AGI limits and holding period rules. The potential benefit is generally largest for investors with long-held, highly appreciated lots and high marginal tax rates.

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Appendix: What changed in 2026

The One Big Beautiful Bill Act (OBBBA), signed in July 2025, made three changes to charitable deductions starting with the 2026 tax year. These changes may reduce the value of the deduction for some donors, but they do not change the capital gains treatment: donors still do not owe capital gains tax on the appreciation of stock they give.

1. A 0.5% of AGI floor for itemizers. Charitable donations are now deductible only to the extent they exceed 0.5% of AGI. For an investor with $2,000,000 of AGI, the first $10,000 of donation each year produces no deduction. The floor applies to every type of donation, including appreciated stock given to a DAF. It costs small annual givers the most: a $10,000 donation at that income level is not deductible at all, while a $500,000 donation loses only 2% of its deduction. Because of the 0.5% AGI floor and the standard deduction, giving several years’ worth of donations in a single year may produce a larger total tax benefit than giving the same amount in smaller annual donations. A single large donation is still subject to the 30% AGI limit, so part of the deduction may need to be carried forward.

2. A 35% cap on the value of deductions for the top bracket. Taxpayers in the 37% bracket used to save 37 cents of tax per dollar deducted. They now save at most 35 cents. On a $500,000 itemized deduction, that lowers the tax savings from about $185,000 to about $175,000. Taxpayers in lower brackets are not affected. The cap reduces the value of the deduction, but not the capital gains tax savings of donating stock instead of selling it and giving cash.

3. A new deduction for non-itemizers that excludes DAFs. Taxpayers who take the standard deduction can now also deduct up to 1,000(2,000 for married couples filing jointly) of cash donations. This deduction only applies to cash given directly to public charities. Donations to DAFs, donations to supporting organizations and donations of stock do not qualify. Investors who give appreciated stock through a DAF still need to itemize to get a deduction.

OBBBA also made the 60% of AGI limit for cash donations to 501(c)(3) charities permanent. The 30% limit for appreciated stock and the five-year carryforward did not change.

What this means for planning: Because the 0.5% floor applies every year, a single large DAF donation that covers several years of giving may lose less to the floor than the same amount in smaller donations made every year. The donor can then recommend grants to charities from the DAF over the following years. Source: Taft Law, Charitable Giving After the OBBBA.

All simulation results in this paper are hypothetical, based on historical data, and for illustration only. They do not reflect actual trading or actual client accounts, and they are not a guarantee of future results. Results depend on the assumptions described in the Simulations section and do not reflect actual trading fees beyond those stated or state taxes. Actual results will vary.

This paper is for informational purposes only. It is not tax, legal or investment advice, or a recommendation to buy or sell any security or use any strategy.

Tax rules are complex and may change. How well this approach works depends on each investor’s full tax and financial situation. Investors should consult their own tax advisors about the tax consequences of investing with Frec and using these strategies. Investors and their tax advisors are responsible for how transactions in their accounts are reported on their tax returns. Frec assumes no responsibility for the tax consequences of any investor’s transactions.

The effectiveness of Frec’s tax-loss harvesting in reducing an investor’s tax liability depends on their entire tax and investment profile. This includes purchases and sales in accounts outside Frec (including a spouse’s accounts), the type of investments (for example, taxable or tax-exempt) and holding periods (short-term or long-term). The securities bought through tax-loss harvesting may perform better or worse than the securities sold.

Investing involves risk, including the risk of loss. Long-short strategies carry additional risk from margin borrowing and short positions.

This paper may be updated at any time to reflect new findings, improve readability or correct inaccuracies.