The purpose of estate tax planning is to maximize the assets you pass on to future generations by minimizing gift and estate taxes. Estate-tax strategies revolve around the use of irrevocable trusts. This article discusses the most common types of irrevocable trusts that are used to minimize gift and estate […]
This article provides a detailed comparison of two strategies that are commonly used to tax efficiently diversify appreciated assets: Exchange Funds (EFs) and Opportunity Zones (OZ).
Opportunity Zones are a popular tax-advantaged investment strategy. Investors who have realized capital gains (from the sale of stocks, real estate, business interests, or other investments) can roll those gains into a special type of real estate investment fund called a Qualified Opportunity Fund (”QOF”). QOFs invest in government-designed geographic areas called “Opportunity Zones” — areas with a lot of poverty and under-investment. An investor who invests in a QOF within 180 days of realizing the gain will receive two valuable tax benefits. First, he or she will be able to defer capital gains on the QOZ investment until it is sold or exchanged, or the end of 2026, whichever comes earlier. Second, the investor will be able to adjust the cost basis of their investment. If the investor holds the investment for at least 10 years, he or she can avoid taxes entirely on the sale of the Opportunity Zone investment. Once the money is in the QOF, the investor’s returns are tied to how well the real estate projects in the QOF perform.
Imagine that Kyle, a 45-year-old California resident, has a $1 million property with a cost basis of zero. He wants to diversify the asset because it has appreciated so much, but he doesn’t need the cash proceeds from the sale. He wants to invest in a QOF, in part because he doesn’t have much real estate exposure in his portfolio. If Kyle doesn’t take distributions for 11 years, rolling his gains into a QOF will increase his post-tax returns by 45% (from $2.2 million to $3.2 million).
An exchange fund, also known as a swap fund, is a financial vehicle designed to help investors diversify their concentrated stock positions without incurring immediate capital gains taxes. The process begins when multiple investors, each holding a significant position in a single stock, contribute their shares to a collective pool.
When a person decides to participate in an exchange fund, they typically start by contributing a significant portion of their concentrated stock position to the fund. This process is similar to making an in-kind transfer to a brokerage account. The investor doesn’t sell their shares on the open market; instead, they transfer ownership of the shares directly to the exchange fund. In return, the person receives an equivalent value of units or shares in the exchange fund itself. Once the investor’s shares are in the fund, they become part of a larger, diversified portfolio. From this point on, the investor’s investment performance is tied to the overall performance of the fund rather than being tied to the performance of their original stock.
During the mandatory seven-year holding period, the investor may receive periodic reports on the fund’s performance, but they typically can’t make withdrawals or changes to their investment.
The tax benefits and returns materialize in different ways. Most important, the initial exchange of shares into the fund doesn’t trigger any immediate tax consequences for the investor. So instead of facing a large capital gains tax bill at that point, the investor pays capital gains tax as they liquidate the position over time. Additionally, if the person holds their fund shares until death, their heirs may benefit from a step-up in basis, potentially eliminating a significant portion of the capital gains tax liability.
Imagine that Sara, a 70-year-old California resident, is an investor in a publicly traded technology stock and that she will pass away in 19 years (based on IRS actuarial estimates). The stock has a cost basis near zero and a fair market value of $1,000,000. She wants to diversify because the stock has appreciated so much, but she doesn’t want to pay capital gains tax on the sale and she doesn’t need the cash. If she uses an exchange fund, she will be able to diversify without selling the asset. When she dies, the cost basis of her assets will be stepped up to fair market value. Thanks in part to the resulting tax savings from the basis step-up, Sara will be able to pass on $2.8 million to her children, about double what she would have been able to pass on if she had just sold the assets without an exchange fund and paid the capital gains tax upfront.
The choice between an Opportunity Zone and an Exchange Fund often depends on an individual’s financial goals, tax considerations, and philanthropic intentions.
Sometimes, the choice is less clear cut. What if an individual is looking to sell an appreciated asset, but isn’t sure if they’ll need the income stream or to what extend they’ll need it? Here are two other factors to consider:
Consider Jane, a tech entrepreneur with a $5 million concentrated public stock position in a successful company she co-founded. Jane is 55 years old and has plans for retirement, with a strong desire to contribute to environmental causes. Her stock has appreciated significantly, and she wants to sell it to support her lifestyle but is concerned about the tax implications of selling her shares.
Assumptions:
Results:
| Opportunity Zone | Exchange Fund | Nothing | |
|---|---|---|---|
| Distributions | $14,694,091 | $22,611,071 | $10,938,782 |
| Capital Gain Taxes | $4,162,246 | $8,366,096 | $3,186,148 |
| Charitable Donation | $0 | $0 | $0 |
| Net distributions after taxes (to you) | $10,531,846 | $14,244,975 | $7,752,634 |
Choosing between an Exchange Fund and an Opportunity Zone requires careful consideration of various factors, including tax efficiency, income needs and investment asset preferences. Both strategies offer unique advantages and potential drawbacks, making it essential to align the chosen approach with the individual’s broader financial objectives. You can use our Comparison Calculator here to understand the financial trade-offs.
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From picking the best strategy to taking care of all the setup and ongoing overhead, we make things simple. The results are real: We have helped create more than $3 billion in additional wealth for our customers. If you would like to learn more, please feel free to explore our Learning Center. You can also see your potential tax savings with our online calculators or schedule a time to chat with us!
