Can ETFs Make Capital Gains Disappear Forever?

The Legal Framework, In-Kind Redemptions and Custom Baskets

Most investors assume their tax bill reflects their own decisions.

In a mutual fund, that's not always true.

A single investor's redemption can force the fund to sell securities to raise cash, realizing capital gains that get distributed to every remaining shareholder.

ETFs avoid this entirely through the creation-redemption process managed by Authorized Participants (APs) where securities are swapped for ETF shares in-kind rather than sold for cash, so no taxable event is triggered inside the fund.

The entire ETF tax efficiency story traces back to a single provision almost nobody has heard of, IRC Section 852(b)(6), enacted in 1969 as a liquidity stopgap that allowed mutual funds to distribute securities rather than cash during redemptions, without recognizing a gain.

Congress was solving a liquidity problem that became the legal foundation for the multi-trillion-dollar ETF industry.

Then, in 2019, the SEC adopted Rule 6c-11 that took this a step further by formalizing "custom baskets," giving managers the ability to choose exactly which securities they deliver to the AP during a redemption.

Rather than handing over a pro-rata slice of the portfolio, a manager can select the most appreciated, lowest-basis positions and manage the fund’s potential taxes.

Five Ways to ‘Wash Away’ Gains

These provisions allow ETFs to swap their most appreciated positions through in-kind redemptions without recognizing gain. The ways in which this gets deployed in practice are creative, verging on audacious.

1. Raising Fund Level Cost Basis (Standard)

This is standard ETF industry practice.

An ETF accumulates positions over time. When APs redeem shares, the manager delivers the lowest-basis, most appreciated positions in the redemption basket.

Repeated over months and years, the gains are continuously exchanged out through the primary market, shifting the tax burden to APs, which as large banks are far better equipped to manage taxes.

If the fund is eventually forced to sell something for cash, the gain is minimal because the remaining positions have relatively high-cost bases.

2. The Dual-Share Class Advantages (Emerging)

By combining a mutual fund and an ETF into a single portfolio, the dual-share class structure gives all investors in the mutual fund most or all the benefits of the ETF shareholders.

Mutual fund redemptions would normally force the manager to sell securities and realize capital gains.

With 2 share classes, the manager can instead route those low-basis positions out through the ETF's in-kind redemption mechanism, no sale, no taxable event.

Vanguard proved this worked over two decades.

Its S&P 500 Index Fund has not distributed a single capital gain since 2001, when its ETF share class (VOO) was added.

3. Dividend Management (In Use)

Both ETFs and mutual funds must distribute at least 90% of their net investment income to maintain their RIC status.

While capital gains can be "washed out" via in-kind redemptions, interest and dividends must pass through to shareholders as taxable income.

To reduce taxable dividend income, some active managers employ strategies to convert ordinary income into capital gains.

One strategy is to use derivatives to replicate fixed-income returns through options-based box spreads.

Another is to use the creation-redemption process and swap out of positions immediately before ex-dividend dates, then get right back in, to capture value as price appreciation, transforming yield into gain and deferring all taxes until the investor chooses to sell shares.

4. Avoiding Forced Capital Gains (Been Done)

Heartbeat trades, named for the EKG-like spikes they create in fund flow data, are large inflow/outflow events designed to remove specific holdings from an ETF.

While the mechanics have drawn scrutiny, Ari Feder, tax attorney at Mintz, notes that the trade "remains squarely within the long-standing statutory framework for in-kind redemptions under Section 852(b)(6) and is not a loophole.”

One valuable use case is with a pending take-private deal.

Normally, if a portfolio company is acquired for cash, the fund is forced to realize a taxable gain on its entire position when the cash hits its account. By executing a heartbeat trade before the deal closes, the manager can move those shares to the AP for them to deal with.

In a high-profile example in 2018, Vanguard reportedly used this mechanism to offload $1.3 billion in Monsanto shares before its Bayer acquisition.

5. Section 351 Exchanges + In-Kind Redemptions (Just Speculation)

We've already established this isn't possible, but the theory is worth understanding.

Section 351 allows an investor to exchange a diversified basket of stocks for ETF shares on a tax-deferred basis, with the fund inheriting the investor's original cost basis in the underlying securities.

Once those low-basis positions are inside the ETF wrapper, the manager can use in-kind redemptions to purge them through transactions with APs, eliminating the unrealized gains inherited from the seeding investors.

In theory, the investor could later on redeem their ETF shares in-kind, receiving a basket of stocks rather than cash, and receive a portfolio at a stepped-up cost basis, having permanently eliminated their capital gains. It's an elegant loop.

It's also illegal, and no one has done it. Here's why.

Why This Is Only Theoretical

There are two completely separate tax accounting systems at play.

At the fund level, the manager tracks the cost basis of every security in the portfolio, and it's this internal ledger where the in-kind redemptions remove low-basis positions.

At the investor level, each shareholder holds their own cost basis in their ETF shares, determined by what they originally paid for the securities. Kip Meadows, founder of Nottingham, a fund administrator, explains, “the fund's tax-cleansing operations' has no effect on the investor's personal basis.

An investor who contributed a low-basis portfolio via a 351 exchange still carries that substituted basis in their ETF shares.” Even after the fund has purged every embedded gain, when an investor eventually sells, they owe taxes on the full appreciation from their original cost.

Back to the Boring Treasury Bills

 The next dual-share class fund to launch likely won't be a boring T-bill mutual fund, it will be an equity fund sitting on decades of low-basis positions and billions in embedded tax liabilities.

Further down the road, clever financial engineers will undoubtedly come up with more new and interesting ways to exploit the tax code until it gives them what they want, a smaller tax bill.

While all of the strategies currently used can’t make taxes go away, while you are alive of course, they can give investors control over the timing.

In a world of cheap market beta, choosing exactly when to pay the IRS is about as close to a free lunch as you’re going to get.

About Matthew Bucklin

Matthew Bucklin is a finance professional and entrepreneur. He is the Founder of ExchangiFi, a capital markets platform that enables ETF issuers to raise seed capital through Section 351 tax-deferred exchanges.

Previously, Matt launched Valley Cove Capital, a search fund focused on small business acquisition and growth, co-founded Sense Relief, a digital therapeutics company, Credible, a speech coaching app, and founded The Quit Company, a smoking cessation products platform. He began his career in asset management with MDRxFinancial and W.P. Stewart.

Matt holds an MBA from the Yale School of Management and a BA in Economics and Mathematics from Colby College. He is based in West Palm Beach, and serves as President of the Yale Club of the Palm Beaches and mentors with the Yale Entrepreneurial Society and Colby Halloran Lab.

Disclaimer

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.