There’s much wisdom in exercising caution when stirring up things long undisturbed. Politicians often run amok in efforts to garner “points” with their constituents. In this case, Mr. Biden ought to have let sleeping dogs lie. His recent attempt to discard the Step-up in Basis Rule, a popular tax loophole, was met with understandable resistance, and he has since relented. His was the third attempt in a century to change this longstanding rule which erases capital gains taxes on appreciated property at each owner’s death. Farming lobbyists reached DEFCON 1 since their constituency knows better than most why cash-poor and land-rich illiquid investors could easily find themselves in a pinch to pay taxes after a death. Without the step-up rule, capital gains taxes could lead to fire sales of properties otherwise handed down from generation to generation.

But Mr. Biden’s failed attempt at scrounging up more revenue has alerted the sleeping population to the power of this lesser-known rule. While my firm has always been deliberate about using this rule within our client tax strategies, the whole country is now on notice, and Mr. Biden might now wish he had picked on another “billionaire’s loophole.”

Another Tax Loophole – The Exchange Fund

Since I’m throwing my drink in Mr. Biden’s face, I might as well go ahead and tell you about another little-known tax loophole – the Exchange Fund.

For decades the IRS has allowed investors to contribute stock to a partnership with other investors in what’s called an Exchange Fund. The idea is that investors can contribute low-basis stock, and then effectively become a proportional owner of the aggregate shares in the partnership. The fund administrators decide whether each incoming applicant’s shares add acceptable company and industry exposure to the group. The incoming shares are locked up for seven years per IRS regulations and experience no trade activity. These funds charge 90 basis points on average annually for the service. At the end of that period, a tax-free distribution of the mixture of shares is allocated to each participant, who receives shares of each company pro-rata and proportionally, with their original cost basis applied to new shares.

During the seven-year lockup, investors can actually leave the partnership early and take back their shares. But the exiting shareholders are not allowed to disadvantage the pool. Instead, investors can take their shares back if they perform worse than the pool or can take back a diminished number of shares if your shares have outrun the rest. Exchange Funds even allow shareholders to pick and choose their preferred names of other stocks in the pool when the end is near, in a best-efforts allocation.

So if you find yourself with a big position of a great performing stock and feel squirmy about the risk but you don’t want to pay the tax from selling it, there is a potential solution. And if your broker has instead convinced you to open a managed account and diversify your shares and go ahead and pay the tax, maybe you should ask her why.

Investors often find themselves with lopsided portfolios which have become so by way of one or two stellar performers. They want diversification, but selling would mean paying taxes and losing their step-up opportunity at death. Exchange funds allow investors with large positions to achieve diversification without any taxable activity. There are certain limits on particular stocks and industry exposure, but many of the issues outlined previously can be fixed with an exchange fund.

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