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COBRA is a “basis-enhancing” shelter. “Basis” represents an investor’s ownership interest in a business entity. If somebody invests $100 in a partnership, for example, his or her basis becomes $100. If that person then sells the partnership interest for $110, he or she shows a capital gain of $10. But through the magic of COBRA, the investor’s basis can be artificially increased to, say, $200. When the partnership interest is sold for $110, the investor not only makes $10, he or she purportedly recognizes a capital loss of $90 for tax purposes. Here’s a (simplified) version of how it works. Caution: Don’t try this at home. STEP 1: Investor forms a single-member limited liability company. STEP 2: The LLC borrows money from an investment bank, then uses that money to buy a long option from the bank and sell a short option to the bank. The net cost to the investor is minimal. STEP 3: A general partnership is created. The LLC becomes a partner, and contributes the option positions and minimal capital assets to the general partnership. The investor’s basis is inflated because he or she claims basis from the contribution of the long position but no reduction in basis from the short position. STEP 4: An S corporation is created. The LLC contributes its interest in the general partnership to the S corporation in exchange for stock. The partnership terminates. STEP 5: The options expire. The S Corporation’s assets are then sold, triggering a capital loss that passes through to the investor. Source: Sheldon Pollack, University of Delaware

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