Exchange Fund: Definition, How It Works, Tax Advantages (2024)

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.

Exchange Fund: Definition, How It Works, Tax Advantages (2024)


Exchange Fund: Definition, How It Works, Tax Advantages? ›

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.

How do taxes work in an exchange fund? ›

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.

What is a benefit of an exchange traded fund? ›

ETFs can offer lower operating costs than traditional open-end funds, flexible trading, greater transparency, and better tax efficiency in taxable accounts.

What is the downside of exchange funds? ›

The Downsides of Exchange Funds

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.

Are exchange traded funds tax free? ›

For most ETFs, selling after less than a year is taxed as a short-term capital gain. ETFs held for longer than a year are taxed as long-term gains. If you sell an ETF, and buy the same (or a substantially similar) ETF after less than 30 days, you may be subject to the wash sale rule.

Do I pay capital gains if I exchange funds? ›

Exchange funds typically reinvest capital gains and dividends. A taxable event occurs once you redeem your partnership shares in the fund, with your cost basis of the fund being the cost basis of the concentrated stock that you handed over (the amount you paid to purchase the stock originally).

Are exchange funds a good idea? ›

Weighing the pros and cons of exchange funds

Exchange funds offer investment diversification and tax-deferral benefits for those with concentrated stock positions. They may be a good option if you're a long-term investor looking to reduce exposure to a concentrated, low cost-basis stock.

What are the advantage and disadvantages of exchange traded funds? ›

Advantages of Exchange Traded Funds
  • Advantages of Exchange Traded Funds. Diversification.
  • Liquidity.
  • Lower cost ratios.
  • Immediately reinvested dividends.
  • Lower discount or Premium in price.
  • Disadvantages of Exchange Traded Funds. Diversification is limited.
  • Intraday pricing could be excessive.
  • Dividend yields have dropped.
Apr 12, 2022

What is an exchange-traded fund for dummies? ›

An exchange-traded fund (ETF) is something of a cross between an index mutual fund and a stock. It's like a mutual fund but has some key differences you'll want to be sure you understand. Here, you discover how to get some ETFs into your portfolio, how to choose smart ETFs, and how ETFs differ from mutual funds.

Are exchange traded funds better than mutual funds? ›

Both can track indexes, but ETFs tend to be more cost-effective and liquid since they trade on exchanges like shares of stock. Mutual funds can offer active management and greater regulatory oversight at a higher cost and only allow transactions once daily.

What is the 7 year rule for exchange funds? ›

To take advantage of the tax benefits of an exchange fund, you are required to hold your shares for at least seven years. They simply do not offer daily liquidity like ETFs or mutual funds.

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 is a major disadvantage of investing in exchange traded funds? ›

At any given time, the spread on an ETF may be high, and the market price of shares may not correspond to the intraday value of the underlying securities. Those are not good times to transact business. Make sure you know what an ETF's current intraday value is as well as the market price of the shares before you buy.

What is an exchange fund to avoid taxes? ›

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. Also, shares in the fund cannot be bought or sold on public exchanges.

How much tax do you pay on exchange traded funds? ›

If the ETFs were held for less than 1 year, the profits are considered to be short-term capital gains. Such gains are taxed at 15% u/s 111A of the Income Tax Act, 1961. However, if you have held the ETFs for longer than 1 year, the profits will be classified as long-term capital gains.

What is the tax rate for exchange traded funds? ›

Not all ETF dividends are taxed the same; they are broken down into qualified and unqualified dividends. Qualified dividends are taxed between 0% and 20%. Unqualified dividends are taxed from 10% to 37%. High earners pay additional tax on dividends, but only if they make a substantial income.

Do you eventually pay taxes on 1031 exchange? ›

You can use the 1031 exchange rules to defer paying capital gains taxes until you sell your final investment property and take that profit without investing in another piece of real estate. Once you stop buying new properties, you'll need to pay all the capital gains taxes that you owe.

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