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Retired Military Finances 401: Exchange Funds Thumbnail

Retired Military Finances 401: Exchange Funds

Investment Taxes

Let's start by checking your reading comprehension. Did you read Exchange Funds or Exchange Traded Funds? This article isn't talking about ETFs that trade on the stock market. It's about an Exchange Fund, a specialized tool for a specialized problem.

What Problem Does and Exchange Fund Help Solve?

Exchange funds can help an individual who has a concentrated position(s) in his or her portfolio. A concentrated position is when one stock (or other security) composes more than about 5% -10% (depending on who you talk to) of your portfolio. Generally speaking, having that much invested in one position is considered risky and you're often not compensated for that additional risk. A concentrated position can result from receiving equity compensation or an inheritance and that position may come with considerable capital gains. Therin lies the problem. You don't want to keep the concentrated position, and you don't want to pay the capital gains tax. Enter the Exchange Fund

How Does and Exchange Fund Work?

An Exchange Fund works a little bit like a 1031 exchange for rental real estate. You exchange one thing for another thing. But to be clear, using an Exchange Fund is not a 1031 exchange (see the article below to learn more about 1031 exchanges).

An Exchange Fund is technically a limited partnership that owns stock (or other securities). To use an Exchange Fund, you exchange your concentrated position for a percentage ownership of the partnership. It is similar to transferring office equipment to a partnership during the start-up phase. The value of the property you transfer becomes all or a part of your basis in the partnership.

If enough partners donate concentrated positions to the Exchange Fund in exchange for a fractional ownership of the partnership, all of a sudden, they don't have concentrated positions. They own a percent of a diversified basket of stocks. At some point in the future the partners will be able to withdraw their portion of the diversified portfolio. No taxes will be due until the shares are sold and the basis will be the basis of the original contributed stocks. An Exchange Fund defers taxes and eliminates concentrated positions. It doesn't make the tax go away.

What are the Downsides of an Exchange Fund?

Exchange Funds are not regulated by the SEC as they are not securities. That adds a level of risk you don't have when buying regulated security like a mutual fund or ETF. Also, you have to be a qualified investor ($5M in investible assets) to participate in an Exchange Fund. The buy-in can be pretty steep too. It's not uncommon to see minimum investments of $500,000 or more of the concentrated position(s). Finally, Exchange Funds are fairly illiquid as you normally can't get your money out in the first 7 years.

Should I Use an Exchange Fund?

For a small minority of Retired Senior Military Officers and NCOs, an Exchange Fund can make good sense. It allows the diversification of a concentrated position with no immediate tax hit. Deferring taxes may allow you to recognize your gains after you're retired, retired and potentially in a lower tax bracket while also eliminating the risk inherent in a concentrated position.

Military Finances are Different

Exchange Funds aren't going to apply to every Retired Senior Military Officer and NCO. Conversely every retired military member has unique financial and tax benefits that their civilian counterparts don't. That's why we think you should work with a financial planner/advisor that works with military and veteran benefits each and every day. If you'd like to see how we work with clients just like you, use the button below to schedule a free, initial consultation.

If you found this article useful, you might like the following blog posts:

Retired Military Finances 201: 1031 Exchanges


Retired Military Finances 401: Restricted Stock and the 83(b) Election


Retired Military Finances 401: What Are Grantor Retained Annuity Trusts (GRATs)?




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