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).

Key Highlights and Takeaways

• Tax-Efficient Diversification: Both Exchange Funds and Opportunity Zones offer strategies to diversify appreciated assets while deferring capital gains taxes, potentially leading to significantly higher returns compared to outright selling.
• Asset & Timing Flexibility: Opportunity Zones offer more asset and timing flexibility as you can contribute realized capital gains (from most assets) after a sale. In contrast, you typically can only contribute a limited amount of specific public stocks to an Exchange Fund to utilize its tax benefits.
• Limited Early Liquidity: Both Opportunity Zones and Exchange Funds offer a limited amount of liquidity in early years, with EFs offering limited liquidity for seven years while OZ’s offer limited liquidity for a decade.

What are Opportunity Zones?

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.

Benefits of Opportunity Zones

1. Tax Deferral: By investing in Opportunity Zones, investors can delay paying capital gains tax on the money they move into the fund until December 31, 2026.
2. Tax Reduction: If the investment is held for at least 10 years, investors can avoid capital gains taxes on the Opportunity Zone investment.

Drawbacks of Opportunity Zones

1. Investment Risk: Returns depend on the success of the QOF’s projects.
2. Limited Liquidity: To get the full tax benefits, investors need to keep their money in the QOF for at least 10 years, which means they won’t have easy access to the capital during that time.
3. Fees: QOFs have high upfront and annual fees.
4. Negative Cash Flow: If you invest now in a fund that closes at the end of 2024, you would likely not have liquid access to your QOF investment funds until at least 2030, but you would owe taxes on your deferred gains at the beginning of 2027. Without proper planning, this could create a cashflow issue for you.
5. Concentrated Real Estate Exposure: Opportunity Zone funds invest in a small number of real estate projects. As a result, investors in these projects wind up with concentrated exposure to two to five real estate projects.

What is an Ideal Opportunity Zone Situation?

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).

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.

Choosing Between Opportunity Zone’s and Exchange Funds

When Does One Clearly Make More Sense than the Other?

The choice between an Opportunity Zone and an Exchange Fund often depends on an individual’s financial goals, tax considerations, and philanthropic intentions.

1. You Don’t Have a Limited Amount of Public Stock: Exchange Funds can typically only accept a limited amount of public stocks, so if you don’t have public stock (or have a large amount of public stock), then you won’t be able to use an Exchange Fund but you could still leverage the tax benefits of an Opportunity Zone.
2. You Already Realized Capital Gains: If you have already sold your appreciated asset, you can’t utilize the benefits of an Exchange Fund, but you may still be able to use an Opportunity Zone if you’ve sold the asset within 180 days. That being said, it really only makes sense to use an Opportunity Zone if you believe the fund is a top decile OZ fund and you want concentrated real estate exposure.
3. You (Don’t) Want Concentrated Real Estate Exposure: Deferring your capital gains with an Opportunity Zone forces you to reinvest your assets in concentrated real estate. An Exchange Fund exposes you to a variety of public stock assets.

Close Calls and Secondary Considerations

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:

1. Solving for Returns and Believe You Have a Top Quartile OZ Fund: Due to fees, you probably need an OZ Fund to have a 15-25% higher return than the stock market to achieve comparable returns, plus you should account for the higher risk because it is a concentrated and non-diversified investment. Which is why it typically only makes sense to use an OZ for a portion of your portfolio and you have high conviction in the OZ fund.

Exchange Fund and Opportunity Zone 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 $190k/year (after taxes) that increase by 5% per year.
• Public Market and Opportunity Zone Investments grow 10% per year.

Results:

• Both structures are significantly better than doing nothing.
• An Exchange Fund distributes ~35% more after taxes to Jane than an Opportunity Zone.

Conclusion

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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