Exchange Funds: The “Rich Person’s ETF” for Tax-Free Diversification
Tax Tips / Diversification
Exchange Funds: The “Rich Person’s ETF” for Tax-Free Diversification
💡 Executive Summary
- Problem: You have $5M in a single stock (e.g., Apple) with a low cost basis. Selling it to buy a diversified index fund triggers a massive 23.8%+ tax bill.
- Solution: Contribute your stock to an Exchange Fund. Other investors contribute their stocks (Google, MSFT, etc.).
- Result: After a 7-year holding period, you can withdraw a diversified basket of stocks. The entire process is a tax-free contribution under IRC § 721.
⚠️ THE 7-YEAR LOCK-UP
To preserve the tax-free status, you generally cannot withdraw the diversified basket for 7 years. It is an illiquid strategy. If you need cash sooner, this is not for you (use SBLOC instead).
To preserve the tax-free status, you generally cannot withdraw the diversified basket for 7 years. It is an illiquid strategy. If you need cash sooner, this is not for you (use SBLOC instead).
“Don’t put all your eggs in one basket” is good advice, but paying 30% of your eggs to the IRS just to move them to a new basket is bad advice. Exchange Funds allow Qualified Purchasers (Tier L2+) to swap their concentrated risk for a diversified portfolio without triggering a taxable sale.
🧐 Core Mechanic: The “Potluck” Party
Imagine a potluck where everyone brings one dish.
• You bring 100% Apple Pie (AAPL).
• Others bring Steak (TSLA), Salad (GOOG), and Wine (MSFT).
• At the end of the party (7 years later), you leave with a “Mix Plate” of everything. Because you never “sold” your pie, you pay no tax.
Imagine a potluck where everyone brings one dish.
• You bring 100% Apple Pie (AAPL).
• Others bring Steak (TSLA), Salad (GOOG), and Wine (MSFT).
• At the end of the party (7 years later), you leave with a “Mix Plate” of everything. Because you never “sold” your pie, you pay no tax.
Performance Simulation
Portfolio Value After 7 Years (6% Growth)
Sell & Diversify (Tax Hit)
$11.4M Final Value
Started with 76% Capital
Exchange Fund (Tax Deferral)
$15.0M Final Value*
Full Compounding
Direct Indexing vs. Exchange Funds
| Feature | Direct Indexing (Art. 614) | Exchange Fund (Art. 625) |
|---|---|---|
| Primary Goal | Harvest Losses | Diversify Winners |
| Liquidity | High (Daily) | Low (7 Year Lock) |
| Tax Impact | Generates Tax Credits | Defers Tax Liability |
“Exchange Funds are the only way to turn a single volatile stock into a stable index fund without volunteering to pay a fortune to the government.”
🔗 Related BMT Playbooks (Internal)
🛡️ The Alternative: SBLOC (If you need cash, not diversification) ⚖️ The Exit: CRT (If you want income and charity, not equity) ✅ The Partner: Direct Indexing (Managing the new basket)🏛️ Institutional Resources (External)
📜 Legal Text: IRC § 721 (Nonrecognition of Gain) 📘 Definition: Investopedia on Exchange Funds 🏛️ Regulation: Accredited Investor Definition
BMT designs for tax reality, not theory.