To diversify a concentrated position in a single stock, investors can simply sell some or all of the position outright, but this transaction, of course, is a taxable event. Tax-sensitive investors often use derivative securities to hedge and monetize their position (read an article discussing exchange-based options strategies and prepaid variable forwards). The use of an “exchange fund” is yet another tool that can be used to achieve the goal of diversification in a tax-efficient manner.

An exchange fund is a partnership (an investment fund) whose partners have each contributed low-cost-basis stock in lieu of cash.  After the contribution to the partnership, each partner owns a pro rata interest in the partnership, which now holds a diversified pool of securities, rather than any low-basis stock.

The contribution of the securities to the partnership does not trigger a taxable event, and the investor’s basis in the partnership units is the same as the basis in the shares that were contributed (e.g., a carryover basis).

For tax purposes in the U.S., each investor must remain invested in the fund for a minimum of seven years. After seven years, the investor typically has the option to either redeem its interest in the partnership and receive a basket of securities equal in value to the investor’s pro rata ownership or continue the investment in the fund. If the investor elects to redeem its ownership interest after seven years, the basket of securities retains the low-cost basis of the original shares contributed to the partnership.

For tax purposes, the transfer of the securities to the partnership in exchange for an interest in the partnership is not a taxable event, assuming that not more than 80 percent of the partnership’s assets consist of stocks. The remaining 20 percent of the portfolio has to be invested for tax purposes in what is referred to as “not readily marketable” securities.

Over the past decade, the U.S. Congress has tightened up considerably what qualifies as “not readily marketable” securities. Until recently, this 20 percent piece could be invested in hedge funds, venture capital, or private-equity-type investments. This practice is no longer allowed. Most exchange fund sponsors now invest in various forms of commercial real estate, such as multifamily residential (e.g., apartment buildings), office properties, and industrial/distribution facilities, as well as triple net lease properties of all types. These investments are generally made through a private REIT structure that the fund sponsor controls through the partnership. The 20 percent piece is sometimes invested in preferred equity interests in real estate operating partnerships that are affiliated with publicly traded REITs. The real estate investments are funded primarily through borrowings, much of which is nonrecourse debt against the properties, which significantly reduces the risk of holding the real estate investments. Typically, the real estate investments generate enough positive cash flow that, together with the dividends received on the stock portfolio, there is sufficient liquidity to pay debt service and fund expenses.

If the partnership disposes of any of the contributed securities, any gain on the disposal will be allocated first to the partner who contributed that stock to the partnership up to the amount of the unrealized gain on the stock when it was contributed to the partnership. Any gain in excess of this amount is allocated to each partner on the basis of his or her share of partnership profits. 
If the partnership distributes any stock within seven years after it was contributed, the contributing partner must recognize gain in the amount of the unrealized gain on the stock at the time it was contributed to the partnership.

Under current U.S. law, if the investor dies while invested in the exchange fund, the investor’s partnership interest achieves a stepped-up basis. If the decedent’s estate then redeems the partnership interest, the estate will receive securities with the same basis as the partnership interest (stepped-up).

The partnership may enter into various types of transactions that do not recognize gain for tax purposes but that do monetize the positions it is holding. In such cases, the partnership can actively manage the portfolio.

Because most exchange funds are designed to exist in perpetuity, most tax practitioners believe that a legislative attack on the tax status of exchange funds would be on a prospective basis rather than on a retroactive basis. The investor can have the reasonable expectation that the unrealized gains will be eliminated at death owing to the stepped-up basis of the partnership interest.

In contrast, most tax practitioners caution investors against implementing derivative security transactions longer than five years because of constructive sale rules. At the end of the term of the derivative contract, most investors wish to settle the current contract for cash and simultaneously “roll into” a new contract with terms and conditions similar to the old one until death, when a stepped-up basis can probably be achieved. This strategy introduces the possibility that the tax landscape for derivative securities might change in five years, when these types of transactions might be prohibited. This scenario is what is meant by exchange fund investors having less tax “rollover risk.”

Criteria for Evaluating and Selecting Exchange Funds
The selection of an appropriate exchange fund is an extremely important decision. Advisers might wish to ask the following questions with respect to exchange fund contributions that their clients are considering:

• How many years of experience has the fund sponsor/investment manager had in managing exchange fund assets? What about the individual portfolio managers?
• What is the amount of exchange fund assets currently under management by the fund sponsor?
• Does the exchange fund have a verifiable, long-term performance record?
• What is the size of the fund being evaluated? Is it a massively diversified portfolio?
• Does the fund have a clearly defined performance objective?
• Is the fund designed to either track or outperform a particular index?
• If so, what has its historical correlation to the index been?
• Is the performance objective merely to be “profitable”?
• Does the fund have an “active” management component to it?
• Is the fund willing and able to accept large contributions?
• Are the fund’s fees and expenses reasonable?
• How do the fees and expenses compare with those of other exchange funds?
• How do the fees and expenses compare with monetizing the position through a derivative (such as a prepaid variable forward) and redeploying the proceeds in an index fund?
• Is there an up-front load? Does it decrease or is it eliminated if the contribution is above a certain size?
• Is the fund periodically open to new investors so that it can be used regularly by a wealth management firm to reduce risk and diversify concentrated positions over time?
• What is the minimum size of a contribution to the fund?
• Can the minimum size requirement be met with the contribution of more than one stock?
• Is there periodic liquidity for investors who may wish to exit the fund?
• What constitutes the 20 percent “illiquid piece” of the fund?
• Is the debt incurred to finance the purchase of the illiquid assets “recourse” or “nonrecourse” to the fund?
• Does the fund use derivatives to any meaningful extent? If so, how are they used?
• Does the fund have a fixed termination date or is it expected to continue indefinitely?
• Should a client decide to redeem its interest in the fund, what will it receive?
• Who is tax counsel to the fund?
• Who is the auditor of the fund?

Exchange Funds vs. Derivative Transactions
Exchange funds are an alternative to derivatives-based transactions. The following are some of the advantages and disadvantages of exchange funds versus hedging and monetization strategies that use derivatives:

Pros

• Investors can diversify a concentrated position while deferring the capital gains tax.
• There is no tax rollover risk.
• Certain funds have verifiable, long-term performance records.
• Certain funds are very large, resulting in massive diversification for investors.
• Although exchange funds inherently use a passive management approach, certain funds have an active management component to them.
• Investors will not be forced to deliver the stock on a derivative hedge (and thus realize a premature gain early) if the stock price drops precipitously. 

Cons

• Investors do not receive cash that can be spent (i.e., position not monetized).
• Investors must remain invested in the fund for a minimum of seven years.
• At least 20 percent of the FMV of the fund at its inception must be invested in illiquid securities that are not readily marketable.
• Managers can return stock to the contributing investor upon the occurrence of certain events, such as a stock-for-cash merger.
• Investors have no control over the fund’s other investments or what stocks are received after the seven-year holding period.
• The current yield on most exchange funds is very low.

Thomas J. Boczar, CFA, is managing partner of Hallmark Capital, an investment banking firm based in New York City that focuses on the tax-efficient monetization of highly appreciated assets.