How exchange funds work: Benefits, tax advantages, and eligibility

Tech employees and accredited investors with large holdings of company stock often face taxable events when selling their stocks, triggering significant capital gains taxes. Exchange funds offer a powerful solution, helping to simplify the tax provision process associated with large capital gains.

Investors can diversify portfolios and reduce exposure to single-stock positions via an exchange fund while optimizing their financial planning and analysis.

What are exchange funds?

An exchange fund is a financial vehicle that allows you to swap your concentrated stock positions—such as large holdings of company stock—for shares in a diversified portfolio. In return, you contribute your stock to the fund and receive an interest in the fund's diversified basket of stocks, mutual funds, or exchange-traded funds (ETFs).

This helps you mitigate risk by moving away from one-stock volatility and achieving diversification. It’s especially relevant for tech employees who may hold a significant portion of their wealth in highly appreciated stock tied to a specific company.

Exchange funds offer a way to shift exposure while deferring taxes on capital gains until you sell the funds, allowing you to benefit from business tax deductions in the meantime.

How exchange funds work

The process of using an exchange fund is straightforward but involves several key steps:

Tax benefits and taxable events

One of the main draws of exchange funds is the ability to defer taxes on your capital gains, which can be further optimized with corporate tax planning strategies. But there are multiple nuances in how taxes are treated, so you have to understand them.

How tax deferral works

When you contribute your concentrated stock positions—large holdings of company stock, for instance—to an exchange fund, you do not trigger an immediate taxable event. Normally, selling appreciated stocks would result in capital gains taxes. However, with an exchange fund, your capital gains are deferred until you sell or redeem the shares in the fund.

For example, if you contribute stock that has appreciated by $500,000, you won't owe taxes on that $500,000 gain until you redeem your shares of the fund. This deferral is a significant advantage, especially for investors looking to manage large stock holdings.

Tax treatment of exchange fund contributions

At the time of contributing to the fund, the IRS allows you to defer taxes on the capital gains. The basis of your original shares is transferred to the fund. This means you don't have to calculate the gain immediately, and you avoid paying taxes on any taxable event.

Basically, your stock contribution is treated like a like-kind exchange under IRS tax law, which means you don’t pay taxes at the point of transfer.

Capital gains tax upon redemption

After the seven-year holding period, when you eventually redeem your shares in the exchange fund, you’ll be subject to capital gains taxes, which can be optimized with smart corporate tax planning strategies. But the good news is, the tax rate on long-term capital gains—for assets held longer than a year—is usually lower than short-term rates.

Let’s say that after 7 years, your shares in the fund have appreciated by another $200,000. When you redeem those shares, the $200,000 is taxed as long-term capital gains at the long-term rate, which could be 15% to 20%, depending on your tax bracket. This is a much more favorable tax rate compared to the short-term tax bill you would face if you had sold the stock outright initially.

Capital gains tax rates and brackets

Here’s an overview of the capital gains tax brackets for long-term investments, as of the latest tax code. This tax-efficient structure makes exchange funds especially beneficial for high-net-worth individuals with large, highly appreciated stock holdings:

• 0% tax rate for long-term gains up to $41,675 (individual) or $83,350 (married filing jointly)
• 15% tax rate for gains between $41,676 to $459,750 (individual) or $83,351 to $517,200 (married filing jointly)
• 20% tax rate for gains above $459,750 (individual) or $517,200 (married filing jointly)

Eligibility and getting started

To participate in exchange funds, certain eligibility requirements must be met:

Accredited investors

You must be an accredited investor, which generally means a net worth of at least $1 million—excluding your primary residence—or an annual income exceeding $200,000 for the last two years.

Qualified purchasers

Some cases call for qualified purchasers, which are investors with $5 million or more in investable assets.

Minimum investment

Exchange funds usually have a high minimum investment requirement. This can range from $250,000 to $1 million, depending on the fund.

Risks and rewards

Exchange funds offer significant tax and diversification benefits, but they come with their own set of risks:

Liquidity

Exchange funds are illiquid during the holding period, which is why accounts payable automation can help track other accessible assets. But even with that help, you won’t be able to sell or withdraw your investment for at least 7 years.

Volatility

Even with diversification, the assets in the fund are subject to market fluctuations. This means there’s still volatility in the value of your shares, even though they’re spread across multiple assets.

Limited control

When you contribute your stocks to the fund, you relinquish control over the individual assets within the fund. You can’t make individual stock choices once your stocks are pooled.

Other considerations for exchange funds

For high-net-worth individuals, exchange funds can serve as a key component of a tax-efficient investment strategy. Since exchange funds allow for the deferral of capital gains taxes, investors can build wealth without worrying about the immediate tax consequences of selling appreciated stock. The 7-year holding period gives the fund time to grow, maximizing the long-term tax deferral benefits.

Exchange funds can also be used in combination with other investment vehicles, such as tax-managed mutual funds or exchange-traded funds (ETFs). These can work in tandem to build a portfolio that balances growth, tax efficiency, and risk management.

Let’s say a tech employee holds a large amount of Nasdaq-listed company stock. Over the years, this stock has greatly appreciated, creating a potential tax burden if sold. Instead of selling the stock and facing a hefty tax bill, the employee decides to contribute the stock to an exchange fund.

The employee now holds shares in a diversified portfolio of ETFs and mutual funds, spreading the risk of having too much exposure to one company. By deferring taxes, they avoid the taxable event and let the investment grow without immediately incurring capital gains taxes.

After the 7-year holding period, the employee can redeem the shares, which will likely be taxed at the long-term capital gains tax rate. That’s a better situation than if they had sold the stock directly initially.

Optimize your tax strategy with Ramp

Managing your investments and deferring taxes on large stock holdings can be complex. With Ramp's accounting automation software, you can simplify these processes, streamline your financial management, and ensure accuracy in your tax planning.

Ramp helps you gain real-time insights and stay organized, automating the tracking of your exchange funds, capital gains, and other key financial data.

Say goodbye to manual calculations and time-consuming data entry. Ramp integrates all your financial data in one place, helping you stay on top of your tax liabilities and portfolio performance. Make more informed decisions faster, with less effort, and focus on what matters most—growing your wealth and achieving your investment objectives.

Explore how Ramp’s accounting automation software can transform your financial management.