The Diversification Loophole: Exchange Funds (Swap Funds)
The Diversification Loophole: Exchange Funds (Swap Funds)
You are “Asset Rich” but “Concentration Poor.” Holding $10M of a single stock is risky, but selling it triggers a $3M tax bill. How to swap your single stock for a diversified portfolio tax-free.
Executive Summary
- The Concentration Trap: Early employees and founders often end up with 90% of their net worth in one stock (e.g., Apple, Google). Financial advisors scream “Diversify!”, but selling to buy an ETF triggers immediate **Capital Gains Tax (23.8% + State)**. You lose 30%+ of your wealth just to play it safe.
- The Solution (Exchange Fund): An Exchange Fund is a partnership where qualified investors “pool” their highly appreciated stocks. You put in $5M of Apple; others put in Microsoft, Tesla, etc.
👉 The Magic: You receive “Shares of the Fund” in exchange. Because this is a contribution to a partnership (Section 721), **no tax is triggered**. You achieved diversification without a sale. - The 7-Year Rule: To make this tax-free swap permanent, you must stay in the fund for **7 years**. If you leave early, you get your original Apple stock back (no diversification). After 7 years, you walk away with a basket of stocks, still with your original low cost basis.
The “Real Estate” Kicker (20% Rule)
The Loophole Requirement: The IRS says you can’t just swap stocks for stocks tax-free (Section 351 prevents this for corporations).
👉 The Fix: Exchange Funds avoid this by holding **20% of their assets in “Illiquid Real Assets”** (usually Real Estate or timber). By mixing stocks with real estate, the fund qualifies as a partnership, keeping the tax exemption alive. You get exposure to real estate as a bonus.
Mechanic: The Swap Structure
Simulation: Diversifying a Concentrated Position ($10M Amazon Stock)
| Feature | Selling Stock (ETF) | Exchange Fund |
|---|---|---|
| Tax Consequence | Immediate Capital Gains | Tax Deferred (Indefinitely) |
| Cost Basis | Resets (Stepped Up) | Carries Over (Low Basis) |
| Diversification | Instant | Instant (Pool of ~50+ stocks) |
“Diversification is the only free lunch in investing, but taxes are the bill. The Exchange Fund allows you to eat the lunch and leave the bill for your estate to pay (or step-up) decades later.”