TRANSCRIPT 🔗
Ken Handy: Everyone, welcome back to Phoenix Private Wealth's Quick Tip Tuesday, the short one that gives you an idea you can actually use. I'm Ken Handy, and I've got my partner here, Dave Baker. Dave, today I want to put you on the spot with a strategy a lot of people have heard the name of, but very few actually understand exchange funds. Not the everyday exchange traded funds. People trade all day, but exchange funds. Funds plural swap. Let's demystify it.
David: Happy to Ken. And and you're right. The name causes total confusion, and that's the perfect
Ken Handy: It does.
David: place to start.
Ken Handy: It it 100% does. So let's set the stage. What problem is an exchange fund trying to solve?
David: So what it does is it solves, or at least it tries to solve, a concentrated stock problem. Okay. Picture a founder or a longtime executive, maybe a long-term investor who has a huge chunk of their net worth in just one single company stock. Very low cost basis, meaning if they sell it to diversify, they owe a big capital gains potential tax bill. So they're stuck. They know that they're overexposed to one company. But the tax cost of fixing it feels like a wall.
Ken Handy: Yeah. They're they're frozen by the tax bill.
David: Exactly. And that's dangerous because while they sit frozen, all the risk is riding on one company. an exchange fund is just one tool designed to help them diversify without triggering an immediate taxable sale. That that that is in essence in a nutshell what it is.
Ken Handy: Okay. So for our quick tip today, let's let's talk about, how does it actually work? Walk me through it like I'm brand new to this.
David: Sure. Okay. So think of it as like a potluck dinner, but for stock. All right. I know, right? love food. Anyway, I know, right?
Ken Handy: Okay, I can't wait. Me too, buddy.
David: so so a bunch of different investors each show up, each one has this big holding, concentrated position, different company. Instead of
Ken Handy: Okay. Okay.
David: everyone selling their own dish, everyone's selling their own thing that they brought, right? They all contribute their shares into one pool or into one spot. Or you put it all on the table with everyone else's. It's the exchange fund, right? Now that pool or that table holds a diversified mix of everyone's stocks that are sitting there.
Ken Handy: Okay, so in your potluck example, I put my one stock in and I get a slice or a piece of the bag of everybody's stocks back. Okay.
David: Right. So instead of having one, depending on how how big the entire pool is, you might have shares of a lot of different companies, or maybe a select few. It just depends on the pool itself. But that's the idea. So in
Ken Handy: Okay.
David: exchange for contributing that concentrated position, you get that ownership interest in that diversified fund, if you will. So your single company risk becomes spread out, diversified basket relative to what it was. Now, because it's in a str or structured as a contribution. into a partnership, because that's how it works. And it's not a sale. Okay. It's a partnership, not a sale. You generally don't trigger capital gains tax at the moment you make the swap. Okay. So that's that's the key and how this kind of works from a tax situation perspective immediately.
Ken Handy: Yeah, I was gonna say that sounds like the magic part. You diversify without selling.
David: Now, yes, that is the headline benefit, right? You've traded concentration
Ken Handy: Okay.
David: for diversification. And you didn't
Ken Handy: Okay.
David: have to write that big tax check on day one to do it. So that that tends to get people's attention.
Ken Handy: That yeah got my attention if I knew nothing about this. And I'm pretending like
David: That's right.
Ken Handy: I don't know anything about it while we're talking about it.
David: Ha ha ha.
Ken Handy: but you you and I both know, right? And if I'm someone listening out there, nothing's free, right? So
David: Well of course.
Ken Handy: what are the catches that people need to know about before they get excited?
David: Good question. Great question. And there are several. Okay. First, within these types of funds, there's generally a holding period. They typically require you to stay in for a long stretch. Now, from what I've seen, historically, seven years is pretty common to get favorable tri tax treatment. So this is not necessarily a liquid thing immediately. So your money is going to be committed for a while. Just keep that in mind in a situation like this.
Ken Handy: Yeah, I was gonna say patience is required at this one. Okay.
David: Big time. Yeah. So so that that that's yeah. now second, the tax isn't erased, to be clear. It's deferred. So when you eventually shell your or shell, when you eventually shell, when you eventually sell your fund interest down the road, your original
Ken Handy: Yeah. Okay.
David: low cost basis will carry over for the most part.
Ken Handy: Okay.
David: depending on the circumstances. So you'll deal with the gain then and only then. But you're you're essentially what you're doing is you're just pushing your tax into the future. You're not making it disappear, though deferral itself does have real value.
Ken Handy: Makes sense to me. So what
David: Yeah.
Ken Handy: what else?
David: All right. So there's also eligibility. So this is important. All right. So not everyone can just
Ken Handy: Go ahead.
David: walk in and say, I want to put my money into an exchange fund. So these have
Ken Handy: Okay.
David: historically been limited to accredited or qualified investors. So there are some wealth and income thresholds that you must qualify for. now, fourth, the fund has rules about what it can hold, right? So a portion has to be in certain illiquid assets to qualify under tax rules. So if you're Essentially trusting the fund's structure and management is what you have to do. you can't like, yeah, I'm
Ken Handy: Okay.
David: still in control of
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this. And I know that that can be very challenging, especially for some founders or business owners or maybe some executives
Ken Handy: Sure.
David: who have had control in the business itself. now the fifth one, well, fees. Because they're costs. You said nothing's free, right? So in any fund,
Ken Handy: Right, it's definitely not.
David: exactly. In any fund, there's going to be management fees and expenses, and you don't get to handpick every or exact which stocks end up in your basket. So, so those are some of the things that You have to give up control control on and and every fund's gonna be a little bit different as it relates to that kind of thing.
Ken Handy: Yeah, and I I was gonna say, see, y you just said it. you've gotta give up some control and some liquidity in exchange for diversification and tax deferral, basically.
David: And and that's essentially it in one sentence. You're you're swapping control,
Ken Handy: Okay.
David: accessing your money for diversification without an immediate tax hit.
Ken Handy: Okay, so who is this actually right for?
David: Okay. So if you're listening to this wondering if this is you, it it tends to fit with a very large, highly appreciated, low basis position who generally wants to diversify. So what do I mean by that? You bought stock at a very low price, it grew tremendously. So so imagine an example where you bought a stock for $5 and now it's trading for $500. Huge growth, right? you want to diversify that. and you want it. you don't need the money to be liquid for the better part of a decade because you still got some running room. So these are for folks that aren't at the finish line, meaning their career's ending, they want to start using this money for retirement and they need access. This is for somebody who has a vision. This is for somebody who's actually planning long term that knows for a fact they're thinking ahead. And these are for the planners and these
Ken Handy: They're thinking ahead. Yeah.
David: are for the people that honestly you should be reaching out to us ahead of retirement to let us know what's really going on and what the the goals are because we're not going to give you cookie-cutter solutions. And this is something that Will play a role in your portfolio that we can help you work on. So to that point, again, not just that stuff, but also you have to be eligible given what we talked about in terms of wealth and income, that thing. So for that person, it can be a really elegant solution for someone or family. for someone who needs flexibility, maybe the position isn't as large, simpler approach, just like maybe selling in tranches over years, that might be a better play. So it it it really it's it's it's fit for certain folks, but it's not fit for everyone.
Ken Handy: Yeah, it's a it's a powerful tool, but it's a specialized one, when it comes to that.
David: Perfectly said. And I'm gonna repeat this because I know I've said this in previous episodes before, but that's what any financial product or strategy is. It's just a tool. It's it. And you when used
Ken Handy: See?
David: in the right situation, it can be awesome. When using the wrong situation, it can be awful. Like for example, I'm not pulling out a driver on the putting green. I'm not gonna do it. Doesn't make any sense. I'm not pulling out the the the putter when I'm
Ken Handy: I hope not.
David: in the T box that is a par five over five hundred yards. I'm not gonna do that. So so to that exact point, it Everything needs a custom approach and a custom tool to make sure it's the right one. And and of course, of
Ken Handy: Absolutely.
David: course, you got to run it by your tax advisor and and your advisor, financial advisor, which of course is if if if if your advisor is not talking about this stuff, please reach out to us. Or if you don't have one, then certainly we can walk you through this stuff. but they have to coordinate because at the end of the day, if they don't, that's a problem. But as w because that can put you in a position where you got one thing right, but maybe not the other, we will coordinate with whoever that person is in your world.
Ken Handy: Absolutely. Dave, love it. So the quick tip today, everybody, if you're sitting on a big concentrated stock position and the tax bill has you frozen, an exchange fund may let you diversify without triggering that immediate tax, as long as you can live with the long holding period and the loss of control. Dave, bring us home.
David: Absolutely. So if you've got a concentrated position and you're not sure whether the your current plan actually addresses it, that's the kind of thing worth a second set of eyes. We welcome a low pressure conversation. Please reach out to our marketing coordinator, director, client engagement. This is Greg Foster. He's at Phoenix Private Wealth. You can email him Gregory.foster at Phoenix Private Wealth dot com or give him a call, four one zero three zero nine three six seven five. Again. Gregory.foster at phoenixprivatewealth dot com or at his phone number four ten three nine thirty six seventy five. He will connect you with either myself or Ken or another advisor on our team who can help you with these types of things. Or maybe it's something else you're thinking about. And this is just something that you're interested in learning about. Just let us know and reach out to Greg. He'll make sure to connect us.
Ken Handy: Still waiting for that crab soup recipe from people out there, Dave. That's your quick tip for the week, everybody. We'll see you next Tuesday. And please be sure to tune into a podcast this upcoming Friday. Thanks again and take care.
David: Thanks everybody.