Exchange funds

In short

If you are holding a big pile of one stock with a very low cost basis, you have probably felt stuck. A friend of mine called it golden handcuffs, and he was not wrong. An exchange fund lets you swap that one stock for a small slice of a shared pool of many stocks, without paying tax on the swap. The trade off for that freedom is time. Under the usual terms, the fund asks you to stay in for seven years, or the tax benefit can be lost. Most funds only take people who meet a wealth test the law sets, so check that first. Ask any fund for its fee table and its rules on what you get back at exit. Read both before you sign anything.

The whole of it

What it is

I once watched an old neighbor sit on a porch and fret over a single oak tree on his land. It was worth more than the whole house, and he could not bring himself to cut it down and pay the bill. Plenty of people feel that way about one stock that grew too big.

An exchange fund is a private pool where many investors drop in their own concentrated stock. Each person gets a share of the whole pool in return. Nobody sells, so nobody pays tax on the swap right away. Your old low basis follows you into the new shares. Basis just means what you originally paid, and it sets how much gain you owe tax on later.

The fund is usually run as a partnership. It is not a mutual fund you open in a few clicks. It is private, it has a minimum, and the people who run it set the terms. You are being invited into a club with rules, and the rules matter more than the brochure.

You have worked hard for what you hold. That is exactly why the choice deserves a calm look.

How it works

A friend of mine once explained a potluck to me this way. Everyone brings a dish, and everyone takes home a little of everything. That is the heart of an exchange fund.

You contribute your shares. So do dozens of others, each with a different company. The fund now owns a mix. Your slice of that mix is far less risky than one stock, since one bad quarter at one company no longer sinks you.

There is a rule that shapes the whole design. Under Section 721 of the Internal Revenue Code, a swap into a partnership can pass without tax. But Section 704(c)(1)(B) says that if the fund hands you different property back within seven years, the old gain can be taxed. So funds ask you to stay seven years.

Many funds also hold a share of their assets in real estate or similar holdings. The reason is a test the tax law applies to keep the swap tax free, and I will leave the fine print to the fund documents. Know that this slice can behave differently from the stock market, and it often carries extra fees.

At the end, you can usually get back a basket of stocks. Your basis in that basket matches your old low basis. So the tax is not erased. It is moved down the road. That is a real gift for some people and a poor fit for others.

The numbers, and where to find yours

You have probably wondered what number lets you in. Most funds only take what the law calls qualified purchasers. The Investment Company Act of 1940 sets that bar, and it is currently the current figure, which the official source publishes each year in investments for an individual. Your own total counts what you hold in investments, not the house you live in.

Next, find your cost basis. Look at your brokerage statement or the trade confirmations from when you got the shares. If you got them through work, check your equity plan records, since the basis may include income you already paid tax on. Basis is the number that tells you how big your hidden gain is.

Now check the tax rate that would apply if you sold outright. The long term capital gains rates are set by law and change by year, so see the current figure, which the official source publishes each year. The net investment income tax adds on top for higher earners, at the current figure, which the official source publishes each year once your income passes the current figure, which the official source publishes each year. The IRS publishes these on its own site, in Topic 409 on capital gains and Topic 559 on net investment income tax.

Last, ask the fund for its fee schedule in writing. Look for the yearly management fee, any fee tied to the real estate slice, and any cost at exit. Those costs are the price of your seven years.

A worked example

Let me tell you about Marcus. He is a software manager who earns 240,000 dollars a year. Over fifteen years his company stock grew until he held 600,000 dollars of it. He paid about 60,000 dollars for it, counting what was taxed along the way. His basis is 60,000 dollars.

His gain is the value minus the basis. That is 600,000 minus 60,000, which equals 540,000 dollars of gain.

Suppose a sale would be taxed at a combined rate of 23.8 percent, which is 20 percent plus 3.8 percent. Check the real rates for your year first. The tax would be 540,000 times 0.238, which equals 128,520 dollars. After paying it, Marcus would keep 600,000 minus 128,520, which is 471,480 dollars to invest.

Now say he joins an exchange fund instead. His 600,000 dollars goes in, and no tax is due on the swap. All 600,000 dollars stays invested in a mix of companies. That is 128,520 dollars more working for him than in the sale.

Marcus pays fees along the way. Say the fund charges 0.75 percent a year on his 600,000 dollars. That is 600,000 times 0.0075, which equals 4,500 dollars a year. Over seven years that is 4,500 times 7, which equals 31,500 dollars, before any growth or loss on the money.

So the gap on paper is 128,520 minus 31,500, which is 97,020 dollars. But he still owes the tax when he finally sells the basket. His basis stays at 60,000 dollars. He has bought time and spread his risk, not erased the bill.

He should also ask what he gets back. If the fund hands him a basket worth about what he put in, he still carries that 540,000 dollar gain forward. Marcus felt relief when he saw this laid out. He had feared he was missing something. He was not.

Where it goes wrong

I know a man who rushed into one of these and regretted it. He needed his money in year four. That was a hard lesson.

Seven years is a long time. If you need cash sooner, you may owe tax on the gain after all. Plan your life before you plan your portfolio.

The fees can eat the benefit. A fund with a high fee and weak holdings can leave you worse off than a plain sale. Always run the math with your own numbers, as Marcus did.

You also give up control. You cannot pick what sits in the pool. You cannot sell one slice whenever you like. And the real estate part adds risk and cost you may not want.

Some people hold stock they plan to give away or pass to heirs. The tax picture there is very different. Section 1014 of the Internal Revenue Code sets the basis of property that passes at death. In general, it resets to the fair market value on the date of death, so the gain built up before then is not taxed to the heirs. Exact outcomes depend on the facts, such as the date of death and how the property is held. Congress can also change these rules, so check the current law. That reset could make an exchange fund pointless. Talk with a tax professional about your own case.

Last, funds can reject you. Not every stock qualifies, and funds often want a spread of industries. Do not count on a yes.

Questions to answer before you leave this page

What is my real cost basis, and have I checked it against my records? Do I meet the investor test the fund requires, and can I prove it? Could I leave my money untouched for seven full years, even if my plans change? What does the fund charge each year, and what does it charge at exit? What will I get back at the end, and what will my basis be? Would a plain sale, spread over a few years, serve me just as well? Do I plan to give this stock away or leave it to heirs, and does that change the answer? Who can I sit down with, such as a tax adviser, to check my numbers before I sign?