This article is dated, but the loophole has not been closed. I searched, but didn't find anything on the subject previously of FW. Hopefully some of you can benefit.
Another Twist For Exchange Fund Loophole Shira J. Boss, Forbes.com
NEW YORK - The trouble with loopholes is that the better they are, the better the chance they'll be closed. For years now, lawmakers have been trying to do away with exchange funds, also known as "swap funds," which allow holders of highly appreciated stock to diversify without paying capital gains taxes.
As recently as last year, there was a congressional proposal to close this loophole, and former President Clinton vowed to sign the legislation if it passed. Though President Bush seems much less likely to do away with exchange funds, given his emphasis on tax cuts in general, it could become a bargaining chip to pass his $1.6 trillion tax package.
"It's something we do monitor pretty closely," says Sharon Henderson, executive vice president of Bailard Biehl & Kaiser, an investment management firm for high net-worth investors in Foster City, Calif. "Even though there isn't anything in the current tax bill, any investor should know that there is always a risk that legislation will be enacted that is averse to exchange funds."
Say you have founders' shares in AOL Time Warner (nyse: AOL - news - people) and want to diversify your portfolio. If you sell shares on the open market, you will take a huge capital gains hit on the appreciation before putting your money to work in another stock. On the other hand, you could contribute those shares to an exchange fund, along with similar people who own different stocks. Seven years later, all the investors could withdraw a basket of stocks from the fund without paying capital gains.
Exact figures are not available, but more than $20 billion is tied up in exchange funds, according to industry accounts. Bessemer Trust's four funds alone house over $1 billion of individual investors' stocks. The recent boom market has presumably led even more investors with skyrocketed stock to check into exchange funds.
Several major investment companies have orchestrated these funds, including JP Morgan (nyse: JPM - news - people), Goldman Sachs (nyse: GS - news - people), Eaton Vance (nyse: EV - news - people), Salomon Smith Barney, a unit of Citigroup (nyse: C - news - people), and Donaldson Lufkin & Jenrette, a unit of Credit Suisse First Boston. "It's clearly targeting a certain profile of investor--that being the wealthiest," Henderson says. Typically investors contribute a minimum of $1 million in appreciated stock, which represents 10% to 20% of their holding.
Technically, exchange funds should be illegal. There is a law preventing people from exchanging one security for a like security without paying taxes. There is also a general rule prohibiting investors from contributing securities to a partnership--which is what an exchange fund is--in exchange for shares in the partnership when the whole purpose is stock diversification.
That's where the loophole comes in. The definitions allow that if at least 20% of the partnership is made up of nonpublicly traded assets then the arrangement is allowed. So exchange fund managers must be careful to keep a balance of preferred, nonpublicly traded stock or other securities that do not fall into the prohibited category.
"One easy way to amend all of this and get rid of exchange funds would be to state that if you have 'x-percentage' of publicly traded securities, it's got to be taxable," says J. Patrick Dowdall, a tax attorney and managing director of the Atlantic Exchange Company in Boston, which specializes in tax-free exchanges.
"The [proposed] legislation rarely says, 'There will be no more exchange funds,'" Dowdall points out. "Instead you get amendments, or changes in the language or the definitions or the exceptions [that could effectively eliminate them]."
Congress has indeed attempted to squelch exchange funds in the past by narrowing the definition or amount of securities that could be in the funds, but the funds have bounced back in reincarnated forms.
"I think it's one of the things Republicans would like to keep in place and the Democrats would like to do away with because they're perceived as tax avoidance schemes [for the rich]," says Rob Elliott, senior managing director at Bessemer Trust, a leading private bank in New York.
If a bill effectively eliminating these funds were ever signed into law, it could apply retroactively. Private bankers who set these up mention this possibility to clients, but typically downplay it. As Dowdall says, "If you make an investment based on certain sets of rules, usually the rules are not changed midstream."
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ETFnerd said: Typically investors contribute a minimum of $1 million in appreciated stock, which represents 10% to 20% of their holding. Interesting information, but I can't see how this could apply to 99.9% of the people on these boards.
FarmerOak said:ETFnerd said: Typically investors contribute a minimum of $1 million in appreciated stock, which represents 10% to 20% of their holding. Interesting information, but I can't see how this could apply to 99.9% of the people on these boards.We're unlikely to participate in a Goldman Sachs exchange fund, but it's not that hard to set one up with a few friends to diversify.
There's another loophole not mentioned: even if the partnership is an "investment company," holding nothing but publicly traded securities, you can contribute appreciated securities tax-free if they are a "diversified" portfolio. It would seem to me that, doing this step by step, you could slowly contribute away your appreciated stock together with newly-bought diversifying investments, getting to the same place eventually.
I wonder how much the lower cap gains rates have affected these strategies though? Would suppose that the AMT impact could still drive people this way.
Wouldn't be suprised if the fees/spreads involved in a GS exchange fund are ahem appreciable.
Your post reminds me of the often seen refrain from didYOUsearch: "Get help from a professional".
I think that you have the appropriate background knowledge to set something like this up, but I don't know if it would be that simple. For example there is a requirement that Exchange Funds may not invest more than 80% of assets in stocks or securities. Thus, Exchange Funds typically invest at least 20% of assets in real estate through REIT operating partnerships. This protects the tax-advantaged nature of the product. Exchange Funds typically leverage 20-25% of their portfolios to meet this requirement.*(as per legg mason)
The net result of this is that the fund needs to be managed to maintain its required leverage above the 20% statutory level. These are also set up in a hedge fund-like structure in order to avoid regulatory requirements.
In the end, I think that what you deem simple may be somewhat complicated to the rest of us.
ETFnerd said: Say you have founders' shares in AOL Time Warner (nyse: AOL - news - people) and want to diversify your portfolio. If you sell shares on the open market, you will take a huge capital gains hit on the appreciation before putting your money to work in another stock. On the other hand, you could contribute those shares to an exchange fund, along with similar people who own different stocks. Seven years later, all the investors could withdraw a basket of stocks from the fund without paying capital gains.
It appears to me that this is not a big deal. The only thing is the investor can avoid paying captial gain for appreciated stock and exchange it for other stock. But he would have to pay that eventually. And that other stock has to be in the fund, i.e. some investor is willing to exchange for his AOL.
That's a lot of risk. Look what happened to AOL now? Hold it for 7 years? Would you do it with your GOOG?
ETFnerd said:Your post reminds me of the often seen refrain from didYOUsearch: "Get help from a professional".I certainly don't mean to imply that this is something anyone should try on their own. But, there's a middle ground between hyper-exotic, cutting edge strategies just for billionaires and the stuff you can pick up in casual chats. This is something that your ordinary, mortal tax lawyer can set up, assuming the various participants have located each other.For example there is a requirement that Exchange Funds may not invest more than 80% of assets in stocks or securities. Thus, Exchange Funds typically invest at least 20% of assets in real estate through REIT operating partnerships. This protects the tax-advantaged nature of the product. Exchange Funds typically leverage 20-25% of their portfolios to meet this requirement.*(as per legg mason)
The net result of this is that the fund needs to be managed to maintain its required leverage above the 20% statutory level. These are also set up in a hedge fund-like structure in order to avoid regulatory requirements.That's what the major, broker-distributed exchange funds do, but it's not necessary to do something that exotic.
Sec. 721(a) establishes the general rule that gain isn't recognized when property is contributed to a partnership. Sec. 721(b) is an exception for a contribution to an "investment company" partnership, which refers to the similar rules for corporations in sec. 351. Those rules explain that the determination will take into account money, foreign currency, stocks, interests in REITs, PTPs, mutual funds, and a bunch of other things, but don't give a simple test at 20%; I haven't checked, and that could be specified somewhere in the regulations, but I think that's just the percentage the brokers have gotten comfortable with, not really based on any hard reasoning.
In addition, as I mentioned, you could have a 100% publicly traded stocks partnership and still qualify when contributing a "diversified" portfolio, which may mean much less than we would consider good diversification -- and there should be nothing stopping you from contributing a bunch of very low basis stock in one company, along with a bunch of other securities you just purchased.
So, again, this isn't something I'd like to try on my own, but it also isn't something just for rocket scientists and jet-setters.
fboyfboy said:ETFnerd said:That's a lot of risk. Look what happened to AOL now? Hold it for 7 years? Would you do it with your GOOG? You can collar the stock for seven years as you tender it into the fund. That should remove most of the downside risk (and some upside).
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