Exchange fund

An exchange fund, also known as a swap fund, is an investment vehicle that allows investors with large stock positions to pool their stocks into a single fund, diversifying their holdings without triggering a taxable event. Given its dependence on the IRS Tax Code, it is a mechanism specific to the U.S., first introduced as early as 1954 with the passage of 26 U.S. Code § 721^[1] though the practice traces back to the 1930s through other tax provisions.

The primary benefit of this arrangement is to diversify a large stock position without triggering a "taxable event". Note that the tax is not avoided, just deferred. Deferring taxes avoids tax drag, as the money lost to taxes remains invested in the market, letting the portfolio compound from a larger base, which could create a significant advantage with time. When the diversified holdings are eventually sold, tax will be due on the difference between the sales price and the original cost basis of the contributed stock.

Detailed structure and eligibility

Fund Structure: Exchange funds are structured as private funds, much like hedge funds or private equity funds. Regulations require that the investors be limited to sophisticated investors, typically accredited investors. Each investor is thus a limited partner in fund.
Investor Eligibility: Most exchange funds only service qualified purchasers^[2] with at least $5 million in investible assets, with minimum investments of $500,000 to $1M at firms like Eaton Vance and Goldman Sachs. Newer entrants like Cache are making them available to accredited investors with minimums of $100,000.^[3]
Fund holding requirements: To qualify for a tax-deferred exchange, an exchange fund needs to hold at least 20% in qualifying illiquid assets like real estate or commodities at each closing.
Liquidity: As per the current IRS code, investors are able to redeem a diversified portfolio without triggering taxable gains after a seven-year holding period. Before seven years, investors can only redeem their own stock back, but at the lower of the value of the contributed stock or their fund ownership.

Benefits and risks

Exchange funds diversify an investor's concentrated position, reducing the overall risk in their portfolio.
Exchange funds provides significant tax alpha, since the entire principal is invested in the diversified portfolio, rather than the smaller post-tax base. A larger asset base should theoretically compound faster.
Exchange funds help investors overcome several biases that can discourage them from diversifying a concentrated position (such as the anchoring bias that occurs when a stock loses value).
Exchange funds are suitable for long-term investors only, as investors must plan to hold it for at least seven years to receive the tax benefits.
Risks associated with exchange funds include liquidity risks, investment risks, tax law risks, leverage risks, and others.

Providers

Historically, exchange funds have been offered primarily by two major investment firms, specifically for their ultra-wealthy clients. Morgan Stanley (through Eaton Vance) is a prominent provider of these funds. Goldman Sachs^[4] offers exchange funds as well. Newer entrants like Cache^[5] offer exchange funds that are more accessible to a broader range of investors.

Regulatory and Policy Questions

Exchange funds became popular after Eaton Vance obtained a private ruling from the IRS in 1975 allowing their use. ^[6] The U.S. Securities and Exchange Commission has investigated the use of these arrangements with reference to the potential for market abuse by directors not disclosing their effective divestment in stocks for which they are privy to sensitive market information.^[7]

In addition, there is general public policy disagreement whether tax revenue that is generated from exchange funds and other like-kind exchanges should be deferred or avoided. Many holders of appreciated positions may elect to hold the concentrated position and borrow against it rather than sell and pay the associated capital gains tax, which results in deadweight loss to the economy. Proponents argue that exchange funds help with this significant deadweight loss as holders of appreciated stock can diversify and liquidate their positions, re-injecting this capital into the economy. Opponents argue that exchange funds only serve a narrow slice of the population. For example, public figures like politician Mitt Romney^[8] and businessman Eli Broad^[9] have been identified as using exchange funds to reduce their tax obligations. Regulatory filings indicate that it is a frequently used strategy by high-ranking corporate executives.

References

^ John A., DiCiccio. "Exchange Funds: The Tax Consequences of a Transfer of Appreciated Stock to a Partnership or a Mutual Fund" (PDF). Delaware Journal of Corporate Law. Retrieved September 18, 2023.
^ "Defining the term "Qualified Purchaser". U.S. Security and Exchange Commission. Retrieved October 13, 2023.
^ Narayan, Srikanth. "What's an Exchange Fund? Pros and Cons for Investors". Cache. Retrieved October 12, 2023.
^ "Goldman Sachs Exchange Funds". Goldman Sachs "Exchange Place" Portal. Retrieved September 29, 2023.
^ "Modern Exchange Funds for your large stock positions". Cache.
^ The Tax Consequences of a transfer of appreciated stock to a partnership or mutual fund
^ www.alwayson-network.com/ Archived October 23, 2006, at the Wayback Machine
^ Confessore, Nicholas (January 27, 2012). "Goldman Sachs Ties Enrich Romney". NBC News. Retrieved October 12, 2023.
^ Henriques, Diana B. (December 1, 1996). "Wealthy, Helped by Wall St., New Find Ways to Escape Tax on Profits". New York Times. Retrieved October 12, 2023.

[1] John A., DiCiccio. "Exchange Funds: The Tax Consequences of a Transfer of Appreciated Stock to a Partnership or a Mutual Fund" (PDF). Delaware Journal of Corporate Law. Retrieved September 18, 2023.

[2] "Defining the term "Qualified Purchaser". U.S. Security and Exchange Commission. Retrieved October 13, 2023.

[3] Narayan, Srikanth. "What's an Exchange Fund? Pros and Cons for Investors". Cache. Retrieved October 12, 2023.

[4] "Goldman Sachs Exchange Funds". Goldman Sachs "Exchange Place" Portal. Retrieved September 29, 2023.

[5] "Modern Exchange Funds for your large stock positions". Cache.

[6] The Tax Consequences of a transfer of appreciated stock to a partnership or mutual fund

[7] www.alwayson-network.com/ Archived October 23, 2006, at the Wayback Machine

[8] Confessore, Nicholas (January 27, 2012). "Goldman Sachs Ties Enrich Romney". NBC News. Retrieved October 12, 2023.

[9] Henriques, Diana B. (December 1, 1996). "Wealthy, Helped by Wall St., New Find Ways to Escape Tax on Profits". New York Times. Retrieved October 12, 2023.

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