Apparently exchange funds have been around for a while but traditionally have large minimum investments. Cache reduces the minimum to $100K.
They are used to diversity highly concentrated positions. According to the article your stock is entered tax free and seven years later you can withdraw a selection of stocks with your initial cost basis if you wish.
Most of us know about 1035 transfers that allow you to move to another annuity, life insurance plan or long term care plan without paying capital gains.
There are also 1031 transfers usually used for investment real estate transfers. It also extends to âinvestmentsâ maybe including stock positions.
âExchanges of corporate stock or partnership interests never did qualifyâand still donâtâbut interests as a tenant in common (TIC) in real estate still do.â
I didnât mention it, I asked about which one has reasonable fees, and it was answered by the person that uses them (Cache). The fees look somewhat reasonable, for deposits over $5M, the fee is 0.5%, so 7 years of fees come to about 3.5%. Perhaps worth the tax deferral and the diversification. Amounts lower than $5M have higher management fees.
I still have a number of questions before I would use their services. For example, since you have to remain in the fund for a minimum of 7 years, is there any contractual guarantee that the expense ratio will remain at 0.5%. Or, once you are locked in, they can raise it to whatever they see fit? And what criteria do they use to determine which stocks they will accept, and how much of a particular stock they would accept? For example, I wouldnât be very happy exchanging my Berkshire Hathaway stock with Junk-r-us stock. I also wouldnât be very happy if I exchange my portfolio overweighted stock, just to become slightly less overweighted in two or three other ones.
Exchange funds arenât set up under Section 1031. Section 1031 is only for real property.
Exchange funds are set up as swaps (one reason that they are also called âswap fundsâ) rather than sales of stock. You are swapping your stock for a limited partnership share in a basket of stocks that must hold at least 20% in illiquid assets (like real estate). The partnership investment must be held for at least 7 years. Other than perusing the list of stocks that are approved for inclusion in the partnership, you donât have a say in what your money is invested in. The investment return of the swap fund is based on the holdings in the fund, which could be better or worse than the stock you originally swapped in. And because of the 7 year minimum holding requirement, you just have to sit back and watch for the 7 years, even if you would have made a different decision about holding some/all of the stocks in the partnership. (I will also note that partnerships issue K-1s, so if you want to simplify your taxes, this probably isnât the way to go.)
If you decide you want to invest in one of these funds, you need to find a fund that will accept the stock you are looking to swap - not always easy, because they set maximums on each stock that they are willing to let in. Then you need tom meet the criteria to be a âqualified purchaserâ - at a minimum, this generally means having at least $5MM in investable assets, and the fund may set some additional requirements, such having an account with a broker in their network.
Hereâs one presentation that I found from Morgan Stanley MSWM about swap funds that has 1 title page, 1 table of contents page, 7 pages of figures and explanations (with some fine print of each of the 7 pages) and 9 more pages of just fine print. Based on that, I would say that you better have some pretty good legal and financial advisory opinions before you decide to swap into one of these investments.
My understanding is that typically, dividends and capital gains are re-invested, but not always. You would have to ask that particular fund how they handle dividends and capital gains, and whether they are put onto the K-1 annually, or if they wait until the 7 years are up.
This would make sense if possible. Because the primary purpose of someone using an exchange fund (âswapâ fund) is to avoid the taxes that would be due upon realizing the gains in the current undiversified holdings. That usually would be people who want to avoid taxable income right now, so presumably they might also want to avoid dividends and capital gain distributions as well.
Except re-investing dividends and capital gains doesnât usually avoid the requirement to declare the income and pay taxes on it. There may be some way that the partnership can shelter it - but itâs not clear to me how. Which is why you would need to understand how the partnership handles it.
Oh, I know this is the case for a mutual fund or an ETF. They pass through dividends (which are taxable now even if reinvested), and they pass through capital gain distributions when necessary (and they are also taxable now). But I was thinking that an exchange fund is organized differently (because of the whole minimum 7 years and 20% illiquid thing) and might be able to internally reinvest any dividends or gains without having to immediately pass them through to the owners of the entity.
It would be VERY nice if they can roll all dividends into the fund by simply reinvesting in shares to keep the fund balanced, without having to pass through any of it! Needs some more research.
I wonder if the dividends alone would be enough to keep the portfolio âin balanceâ, or if there would have to be some asset sales to do so.
And then, somewhere in the back of my mind is a niggling thought about partnerships passing through income so that the partners pay the taxes, rather than the partnership. But I donât know if the lock-up period would allow the income to be deferred. That said, even if it deferred, the deferral would just be compounding the capital gains tax issue that was already deferred when you swapped in, and hopefully is continuing to grow with gains in the swap portfolio. So that leads back to the solution of getting a step up when you die. But you could get a step up without swapping into the swap fund. So basically what you are paying the swap fund for is to diversify your assets, not really to âsolveâ your tax problem.
I doubt dividends alone would be able to do it, the dividend yield of the S&P500 is pretty low, and the dividend yield of the stocks in the QQQ is even lower (this particular fund, Cache, attempts to match the QQQ). Apparently they do most of their balancing via accepting or declining new entrants into the fund. If the fund has too much Nvidia, and someone approaches them with another $10M of Nvidia, they may make that person wait for balance, or wait for a new fund to open, or simply decline to take them on as a customer.
That is the exact question - does it only help alleviate the diversification problem, or does it also help defer some additional taxes? I still donât know the answer, though some of the fund literature seemed to indicate to me that it provides both (Iâm trying to find some specific quotes in the literature, but of course I canât find them right now).
Current dividend yield are generally below 2% (S&P 500 is 1.65%, VTSAX is 1.22%, APPL is 0.45%, NVDA is 0.03%). It doesnât appear that there would be a lot of value in deferring dividend income, since Federal taxes max out at 23.8% for qualified dividends. If the investment allows you to defer 1% in qualified dividends, thatâs $10k in dividends for every $1MM swapped in, for a tax deferral (at most) of $2,380 per $1MM. Doesnât seem like a lot of benefit.