This article provides a detailed comparison of two strategies that are commonly used to tax efficiently diversify appreciated assets: Exchange Funds (EFs) and Deferred Sales Trusts (DSTs).

Key Highlights and Takeaways

• Asset Flexibility: Deferred Sales Trusts offer more asset flexibility as you can use the strategy with most types of assets (business, public stock, real estate, etc.) while you typically can only contribute a limited amount of specific public stocks to an Exchange Fund to utilize its tax benefits.
• Limited Control: Both Deferred Sales Trusts and Exchange Funds give you no direct control over your investments inside the structures.
• Legal Gray Area: Deferred Sales Trust’s exist in a legal gray area that is under increasing IRS focus while Exchange Fund’s do not have much gray area but have more constraints and restrictions.

What is an Exchange Fund?

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.

How Do Exchange Funds Work?

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.

Benefits of Exchange Funds

1. Diversification: Exchange funds offer immediate diversification, reducing the risk associated with holding a concentrated stock position.
2. Tax Deferral: An exchange fund allows investors to defer capital gains taxes by exchanging their concentrated stock for a diversified portfolio of securities.

Drawbacks of Exchange Funds

1. Minimum Investment/Fees: Exchange funds typically require significant minimum investments and have high fees, which can produce lower returns compared to other strategies.
2. Asset Limitations: Most exchange funds accept only public company stock.
3. Liquidity: As described above, an exchange fund’s investors are locked in for seven years.

What is an Ideal Exchange Fund Situation?

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.

Deferred Sales Trusts

A Deferred Sales Trust is another strategy for deferring capital gains taxes. This strategy allows you to sell an appreciated asset and reinvest the proceeds without paying capital gains taxes immediately. Instead, the sale proceeds are placed into a trust, which can then be reinvested in a variety of assets, such as stocks, bonds, or real estate. DSTs are considered somewhat more aggressive than most conventional tax-minimization strategies.

How Do DSTs Work?

1. Initial exchange. The individual sells the asset to a trust in exchange for a promissory note. The promissory note requires that the trust pay the seller back (plus interest) in installments over a number of years (typically 10 years) as long as the trust has enough money to cover the payments.
2. Taxable payments. The seller pays taxes on the installment payments as they are received, rather than owing all of the taxes upfront. This is the key to the DST’s tax deferral value proposition.
3. Asset sale. Meanwhile, the trust sells the asset to a third-party buyer. This is the buyer who the seller would have otherwise sold the asset to. The buyer pays the same price he or she would have paid anyway, typically the same value as the installment note.
4. Reinvestment. The proceeds from this sale are then reinvested inside the trust in income-generating assets like stocks, bonds, etc.
5. Distributions. The income that the trust generates is distributed to the seller, who pays tax on that income. After the installment note is paid off, the remaining trust assets pass to the trust’s beneficiaries.

Benefits of DSTs

1. Tax Deferral: A DST allows you to defer capital gains tax, giving you more money to reinvest in the short term.
2. Post-Sale Investment Flexibility: You can reinvest the sales proceeds in a wide range of assets, from stocks and bonds to real estate and more.

Drawbacks of DSTs

1. Complexity and Cost: Setting up a DST is complicated and requires professional assistance that is very expensive.
2. Misaligned Investment Incentives: If the trust investments do poorly, the trust may not have enough assets to pay you back the money it owes you (via the installment note). On the other hand, if the trust investments do well, you do not benefit from that investment growth.
3. Legal Risk: A DST is a type of “installment sale.” Installment sales are legal, but they have been under increased IRS scrutiny. The IRS even placed certain types of installment sales, known as monetized installment sales, on the IRS’s “dirty dozen” list alongside things like Conservation Easements.
4. Illiquidity. Once assets are transferred into the trust, a portion of the principal is inaccessible to the seller.
5. Lack of Industry Recognition. Some entities, such as Qualified Intermediaries in 1031 exchanges, may not recognize DSTs as a valid exchange alternative. This can create issues if the Qualified Intermediary refuses to release funds to the DST trustee.

Choosing Between an Exchange Fund and Deferred Sales Trusts

The choice between a Deferred Sales Trust and an Exchange Fund often depends on an individual’s financial goals and various tax considerations.

1. You Don’t Have Public Stock: Exchange Funds can typically only accept a limited amount of public stocks, so if you don’t have public stock (or have too much public stock), you won’t be able to use an Exchange Fund but could still leverage the tax benefits of a Deferred Sales Trust.
2. You are Worried About Legal Gray Areas: If you are looking for a conservative approach, an Exchange Fund might be the better choice. Deferred Sales Trusts are a type of installment sale, and installment sales in general have been under significant IRS scrutiny in recent years. In contrast, Exchange Funds are much more conservative.
3. You Want All the Sales Proceeds over the Next Eight Years: Exchange Funds deliver higher returns the longer they are held. On the other hand, DSTs perform worse the longer the time frame. So DSTs will make the most sense if you want tax deferral on the sale and want the proceeds in the next eight years.

Exchange Fund and Deferred Sales Trust Case Study

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:

• Annual distributions starting at $190,000/year (after taxes) that increase by 5% per year.
• Public stock investments grow 10% per year.

Results:

• Both structures are significantly better than doing nothing.
• An Exchange Fund distributes ~55% more after taxes to Jane than a Deferred Sales Trust.

Conclusion

Choosing between a Exchange Fund and a Deferred Sales Trust 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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