Exchange Fund: An Alternative Tax Strategy

An exchange fund helps investors defer taxes from capital gains through various processes that diversify their savings. They’re also known as a swamp fund and allow you – the investor – to exchange your holdings while saving money from capital gains taxes. But, what are exchange funds, and why are they so helpful?

What is an Exchange Fund?

‍An exchange fund, or swap fund, is similar to a mutual fund but, instead of contributing cash, the fund owners contribute stock. By aggregating the concentrated stock positions of many investors, an exchange fund allows you to substitute or replace your own concentrated stock position with a diversified basket of stocks of the same value, reducing portfolio risk and putting off tax consequences until later.

Why Use An Exchange Fund?‍

Because the transaction is not immediately taxed, you can diversify without paying taxes upfront. Because of exchange funds’ limited partnership structure, U.S. tax law allows investors to swap highly appreciated stock for shares of ownership in these entities without triggering capital-gains tax.

How Does An Exchange Fund Work?

‍To qualify as an exchange fund, at least 20% of the portfolio must be in “illiquid” investments like real estate. Additionally, to qualify for favorable tax treatment, the investor must hold fund shares for at least seven years. At the end of seven years, the investor has the option to receive a basket of stocks, none of which is their original stock. The number of stocks received varies by fund but is usually at least 20 or 25 different securities.

The Benefits of Exchange Funds

By contributing to an exchange fund, the investor can achieve instant diversification without immediate tax consequences. If the investor makes a withdrawal after seven years, he or she will receive a proportionate share of the basket of stocks, with a basis equal to what was originally contributed. None of these transactions is subject to taxation until and unless the shares received are actually sold.

What happens to your original cost basis? The original basis is assigned to the basket of stocks you received. This task is performed by the client’s CPA, not the fund, which can add some cost and complexity to managing the process.

The Downsides of Exchange Funds

  1. Holding Period. Exchange funds require a seven-year holding period. If you want to sell the equity before then you may face fees and additional taxes — you would typically receive the lesser of the value of the original stock or the fund shares, and you would lose some of the tax benefits while still being on the hook for applicable fund fees.
  2. Costs. Annual management fees typically range from 1.50% to 2.00%.
  3. Limited Accessibility/Search Costs. These funds are often structured as limited partnerships, and they close to new investors once they have reached their target capacity. And even when you find a fund that is available, the shares you own may not be accepted by the fund you’re trying to exchange into; most funds accept only shares from mid- and large-cap companies. And finally, there’s a good chance the fund will only accept a portion of the shares you are offering.
  4. Contribution Minimums. Funds minimums often run from $500,000 to $1 million.
  5. No Margin. Most exchange fund investments are not marginable, meaning you cannot take margin loans on the assets you’ve contributed.

Exchage Funds: An Example

Let’s say you are looking to diversify out of a low-basis, concentrated stock position worth $5M — shares in a public company, for example. If you chose to diversify by selling, you would incur federal and state taxes totaling approximately $1.5M (depending, of course, on which state you live in). This is the scenario with the highest tax exposure.

If you decided to use an exchange fund, it might be able to absorb the $5M of stock. In order to participate, you would have to certify that you were a “qualified investor.” The ongoing expenses are 150 basis points per year — around $75,000 at the outset, and growing with the value of the fund portfolio.

After 20 years with an exchange fund (and assuming a typical growth rate), you could have around $18.5m on a pre-tax basis; if you sold the assets without this structure in place (assuming the same growth rate, minus fees), you might have around $16.3M. That’s an additional $2.2M, or 13%, with an exchange fund.

exchange fund example
Total Payouts Comparing Exchange Funds vs Not Using Any Structure

Are Exchange Funds Safe?

Exchange funds can help diversify large, concentrated positions, assuming that you don’t need access to the capital for at least 7 years. In other words, they’re better than doing no tax optimization. But these funds might not make sense for periods longer than 7 years, as the ongoing management fees could drag down returns compared to alternative tax planning strategies.

Are Exchanging Funds Taxable?

You’ll owe taxes on your realized gain, when selling shares of a mutual fund or ETF (exchange-traded fund) for a profit. But even if you haven’t sold any shares, you may also owe taxes if your assets realize in gains by selling a security for more than the initial purchase price.

Next Steps

Keep up with next steps by reading our primer on Opportunity Zones and how to take advantage of them for realized gains. Check out our CRT calculator to know your potential return on investment, or set up a meeting with our team at Valur.

About Valur

We have built a platform to give everyone access to the tax planning tools of the ultra-rich like Mark Zuckerberg (Facebook founder), Phil Knight (Nike founder) and others. Valur makes it simple and seamless for our customers to utilize the tax advantaged structures that are otherwise expensive and inaccessible to build their wealth more efficiently. From picking the best strategy to taking care of all the setup and ongoing overhead, we make take care of it and make it easy.