What Is an Exchange Fund?
An exchange fund, also known as a swap fund, is an arrangement between concentrated shareholders of different companies that pools shares and allows an investor to exchange their large holding of a single stock for units in the entire pool's portfolio. Exchange funds provide investors with an easy way to diversify their holdingswhile deferring taxes from capital gains.
Exchange funds should not be confused with exchange traded funds (ETFs), which are mutual fund-like securities that trade on stock exchanges.
Key Takeaways
- Exchange funds pool large amounts of concentrated shareholders of different companies into a single investment pool.
- The purpose is to allow large shareholders in a single corporation to exchange their concentrated holding in exchange for a share in the pool's more diversified portfolio.
- Exchange funds are particularly appealing to concentrated shareholders who wish to diversity their otherwise restricted holdings.
- They also appeal to large investors who have highly appreciated stock that would be subject to large capital gains taxes if they sought to diversify by selling those shares to purchase others in the market.
How Exchange Funds Work
Theexchange fundtakes advantage of there being a number of investors in similar positions: holding concentrated stock positions and wishing to diversify. Several investors pool their shares into apartnership, and each receives a pro-rata share of the exchange fund. Now the investor owns a share of a fund that contains a portfolio of different stocks—which allows for some diversification. This approach not only achieves a measure of diversification for the investor, but it also allows for the deferral of taxes.
Because an investor swaps shares with the fund, no sale actually occurs. This allows the investor to defer the payment of capital gains taxes until the fund's units are sold. There are both private and public exchange funds. The former provides investors with a way to diversify private equity holdings, while the latter offer shares containing publicly traded firms.
Exchange funds are designed to appeal primarily to investors who previously focused on building concentrated positions on restricted or highly appreciated stock, but who are now looking to diversify. Typically, a large bank, investment company, or other financial institution will create a fund, targeting a certain size and blend in terms of the stock that is contributed.
Participants in an exchange fund will contribute some of the shares they hold, which are then pooled with other investors’ shares. With each shareholder that contributes to it, the portfolio becomes increasingly diversified. An exchange fund may be marketed towardexecutives and business owners, who have amassed positions that typically are centered on one or a handful of companies. Participating in the fund allows them to diversify those heavily concentrated positions of stocks.
Exchange Fund Requirements
Exchanged funds may require potential participants to have a minimum liquidity of $5 million cash to join and contribute. Exchange funds will also typically have a seven-yearlock-up periodto satisfy the tax deferral requirements, which could pose a problem for some investors.
As the fund grows, and when enough shares have been contributed, the fund closes to new shares. Then, each investor is given interest in the collective shares based on their portion from the original contributions. The shares in the fund moved to the exchange fund are not immediately subject to capital gains taxation.
If an investor decides they wish to leave, they will receive shares drawn from the fund rather than cash. Those shares will be dependent on what has been contributed to the fund and is still available. Up to 80 percent of the assets in an exchange fund can be stocks, but the rest must be made up of illiquid investments, such as real estate investments.
FAQs
An exchange fund is a tax-efficient private fund owned by investors who exchange their individual stock for shares in the fund. Exchange funds only accept “in-kind” stock contributions, not money.
What are the tax advantages of exchange funds? ›
Exchange funds provide investors with an easy way to diversify their holdings while deferring taxes from capital gains. Exchange funds should not be confused with exchange traded funds (ETFs), which are mutual fund-like securities that trade on stock exchanges.
What are exchange traded funds advantages and disadvantages? ›
In addition, ETFs tend to have much lower expense ratios compared to actively managed funds, can be more tax-efficient, and offer the option to immediately reinvest dividends. Still, unique risks can arise from holding ETFs as well as tax considerations, depending on the type of ETF.
How are exchange traded funds taxed? ›
Dividends and interest payments from ETFs are taxed similarly to income from the underlying stocks or bonds inside them. For U.S. taxpayers, this income needs to be reported on form 1099-DIV. 2 If you earn a profit by selling an ETF, they are taxed like the underlying stocks or bonds as well.
Do I pay capital gains if I exchange funds? ›
If you move between mutual funds at the same company, it may not feel like you received your money back and then reinvested it; however, the transactions are treated like any other sales and purchases, and so you must report them and pay taxes on any gains.
What is the downside of exchange funds? ›
The cons of exchange funds usually apply to people who have a shorter-term time horizon or low-risk tolerance because: Limited liquidity: In order to benefit from the tax advantages of an exchange fund, you must hold it for seven years.
What is an exchange for tax purposes? ›
A 1031 exchange is a tax break. You can sell a property held for business or investment purposes and swap it for a new one that you purchase for the same purpose, allowing you to defer capital gains tax on the sale.
Why are ETFs more tax-efficient? ›
Although similar to mutual funds, equity ETFs are generally more tax-efficient because they tend not to distribute a lot of capital gains.
What is an exchange traded fund for dummies? ›
Exchange-traded funds (ETFs) are a type of index funds that track a basket of securities. Mutual funds are pooled investments into bonds, securities, and other instruments. Stocks are securities that provide returns based on performance.
Why is ETF not a good investment? ›
ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.
Most ETF income is generated by the fund's underlying holdings. Typically, that means dividends from stocks or interest (coupons) from bonds. Dividends: These are a portion of the company's earnings paid out in cash or shares to stockholders on a per-share basis, sometimes to attract investors to buy the stock.
How do I avoid capital gains tax? ›
Use tax-advantaged accounts
Retirement accounts such as 401(k) plans, and individual retirement accounts offer tax-deferred investment. You don't pay income or capital gains taxes at all on the assets in the account. You'll just pay income taxes when you withdraw money from the account.
Is exchange gain or loss taxable? ›
Foreign exchange gains and losses are taxable and deductible respectively if the gains and losses are: arising from revenue transactions; realised; arising from a trade.
When to use an exchange fund? ›
When should I use an exchange fund? Use them if your investment horizon is at least seven years. Use them if you have highly appreciated stock positions and you'd like to reduce your tax burden. Use them to reduce exposure and risk from a particular stock in your portfolio.
What are the alternatives to exchange funds? ›
Alternative Investments Alternative investments include hedge funds, public and private offerings, low expense and high expense, liquid and illiquid, long-only and long-short investments such as master limited partnerships (“MLPs”), commodities, real estate, private equity, collectibles and venture capital.
Do I have to reinvest all proceeds in a 1031 exchange? ›
If you're completing a 1031 exchange, you must reinvest all your profits into your replacement property for it to be completely tax-free. If you don't reinvest the entire amount, the amount left over is immediately taxable.
Are exchange traded funds more tax-efficient than mutual funds? ›
ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold.
What are the tax benefits of foreign investments? ›
Foreign tax credit: If a foreign investor pays income tax in their home country on their U.S.-sourced income, they may be able to claim a foreign tax credit on their U.S. tax return, reducing their U.S. tax liability.
What are the pros and cons of the 1031 exchange tax strategy? ›
Pros of 1031 Exchanges:
- Deferring Capital Gains Tax. The biggest pro of 1031 exchanges is being able to defer capital gains taxes. ...
- Exposure to New Markets. ...
- You Can Literally Keep Deferring the Taxes Until You Die. ...
- No Access to Your Capital, You Have to Roll It. ...
- Complicated Structure.
The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.
