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 cash. Also, shares in the fund cannot be bought or sold on public exchanges.
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 is the key advantage of exchange traded fund? ›
Positive aspects of ETFs
The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.
Do you pay taxes when you exchange funds? ›
Just as with individual securities, when you sell shares of a mutual fund or ETF (exchange-traded fund) for a profit, you'll owe taxes on that "realized gain." But you may also owe taxes if the fund realizes a gain by selling a security for more than the original purchase price—even if you haven't sold any shares.
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.
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.
How does a tax free exchange work? ›
A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like-kind and equal or greater value.
How does exchange traded funds work? ›
ETFs or "exchange-traded funds" are exactly as the name implies: funds that trade on exchanges, generally tracking a specific index. When you invest in an ETF, you get a bundle of assets you can buy and sell during market hours—potentially lowering your risk and exposure, while helping to diversify your portfolio.
What is a major disadvantage of investing in exchange traded funds? ›
The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment. So if you buy an S&P 500 ETF and the S&P 500 goes down 50%, nothing about how cheap, tax efficient, or transparent an ETF is will help you.
Are exchange traded funds a good investment? ›
If you're looking for an easy solution to investing, ETFs can be an excellent choice. ETFs typically offer a diversified allocation to whatever you're investing in (stocks, bonds or both). You want to beat most investors, even the pros, with little effort.
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.
Do you eventually pay taxes on 1031 exchange? ›
It's important to remember that a 1031 exchange only delays taxes; it doesn't eliminate them. A tax bill eventually comes due if you sell the replacement property and don't reinvest the proceeds into a new property with another 1031 exchange.
Which companies offer exchange funds? ›
Goldman Sachs, Eaton Vance, Morgan Stanley, and Cache all offer slightly different approaches to exchange funds, so it may be worth talking to a financial advisor about which is best for you.
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.
What is the typical fee for exchange traded funds? ›
Trading commissions
Also known as ETF transaction fees or ETF transaction costs, these may range from $8 to $30 at brokerage firms. Trading commissions are charged per trade, so they can add up if investors buy and sell a lot—and they're usually more expensive when an order is placed in person or over the phone.
What are the tax benefits of investment funds? ›
One of the main features of investment funds is that they are exempt from taxation until they are redeemed. In other words, they are taxed when you decide to withdraw the money invested or the returns.
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.
