An exchange fund helps investors diversify their concentrated public and private stocks while avoiding . triggering capital gains taxes. But, what are exchange funds, and why are they so helpful?

What Are Exchange Funds?

‍An exchange fund, or swap fund, is similar to a mutual fund but, instead of contributing cash, investors 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. Importantly after you have exchanged your concentrated position for a diversified basket of stocks you will still have to pay capital gains taxes when you sell the diversified stocks (unless you use a Charitable Remainder Trust) but because you now have a diversified basket of stocks it is less pressing for you to sell your shares and face the capital gains taxes.

Why Use Exchange Funds?‍

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, both public and private, for shares of ownership in these entities without triggering capital-gains tax.

How Do Exchange Funds 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. In other words, you keep your cost basis even after you’ve received your diversified bucket of shares. 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 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% (however we are starting to see partners drop these fees dramatically for both public and private exchange funds – closer to 0.8% for public stock exchange funds and 1.25% for private exchange funds.
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. This also is starting to change with both our public market exchange funds starting to take most publicly listed companies and exchange funds for private shares becoming an option.
4. Contribution Minimums. Funds minimums often start at $100,000.
5. No Margin. Most exchange fund investments are not marginable, meaning you cannot take margin loans on the assets you’ve contributed.

Exchange 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.

What are alternatives to Exchange Funds?

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. If you are wondering what alternatives to exchange funds, here are a few:

• Sell appreciated assets in a tax-exempt trust through Charitable Remainder Trusts which offer more flexibility, liquidity and lower annual fees
• Opportunity Zones: These allow you to rollover capital gains into a real estate investment in specific US locations and defer your taxes till 2026. But the recent Opportunity Zone investment vintages have not performed that well.
• Buy renewable energy projects that make you eligible for significant government tax incentives that lower your capital gains tax bill. 
• Reduce your taxable income with charitable deduction tax strategies such as Charitable Lead Annuity Trusts and Conservation Easements.

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’ve built a platform to give everyone access to the tax and wealth-building tools typically reserved for wealthy individuals with a team of accountants and lawyers. We make it simple and seamless for our customers to take advantage of these hard-to-access tax-advantaged structures. With Valur, you can build your wealth more efficiently at less than half the cost of competitors. 

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!