All kinds of in kind: Comparing three types of tax-smart transitions

For many clients, tax management in a portfolio transition is all about moving assets from point A to point B in as tax-efficient a manner as possible. In fact, across the J.P. Morgan Tax-Smart SMA platform, a significant proportion of accounts are funded “in kind”—directly transferring existing stocks, mutual funds and/or ETFs into the new account—as clients seek to transition out of legacy positions and move toward a targeted index or active strategy.

While Tax-Smart SMAs have gained prominence both in the industry and within client portfolios, exchange funds, and, more recently, 351 ETF exchanges, have also entered the conversation about how investors can change their existing allocations in a tax-efficient manner. However, we often see confusion around the way these strategies work and the realities of what they offer. This piece intends to provide an overview on each approach and summarize the respective pros and cons.

Three unique strategies

Before we compare and contrast each strategy let’s define each one:

Tax-Smart SMAs involve a client directly holding individual equity securities in their own separately managed account, with the flexibility and ownership of these securities unlocking opportunities to pursue tax-smart transitions, on-going tax-loss harvesting and/or tax-smart gifting and withdrawals.

351 ETF exchanges use Section 351 of the U.S. tax code, which enables an individual to transfer property (such as investment assets) into a corporation (in this case, a fund) with no immediate tax consequence. This provision has recently been used in ETF fund launches, where individual investors seed a newly created ETF with existing assets and effectively exchange their assets for shares of the ETF.

Exchange funds are similar to 351 ETF exchanges, in that an investor contributes existing holdings in exchange for shares of a fund, with no immediate tax impact. However, exchange funds are private funds, rather than ETFs (leveraging Section 721 of the U.S. tax code rather than Section 351).

Let’s take a closer look at how these three strategies work in practice and the pros and cons that investors will want to consider in the context of their own unique situation.

Tax-Smart SMAs

When a client is transitioning into a new account, Tax-Smart SMAs do not offer the potentially instantaneous and tax-free diversification of exchange funds and 351 ETF exchanges. However, Tax-Smart SMAs can still achieve significant diversification benefits over time, even for clients with concentrated stock positions, and they offer additional tax benefits that the other funds do not.

For example, if a client is willing to pay some taxes in divesting a portion of their concentrated holding, the manager running the Tax-Smart SMA can pare down the legacy exposure while also reinvesting the proceeds in securities with complementary risk: a low-beta, defensive stock could be surrounded with more volatile, growth stocks, or vice versa. The case study in Stay one step ahead: Leveraging Tax-Smart SMAs throughout the investing lifecycle illustrates this concept in more detail.

The SMA structure—where clients own a range of individual securities rather than shares in a fund—offers another layer of tax-smart options. As also discussed in Stay one step ahead, Tax-Smart SMAs offer tax-loss harvesting that can continue beyond an account’s initial tax-smart transition,¹ and provide additional benefits when clients want to access their capital for gifting or spending. For example, gifting stocks with a lower cost basis removes the overhang of capital gains in the portfolio faster and maximizes the potential deduction of adjustable gross income associated with donations. Spending from proceeds of stocks with higher cost bases creates a lower effective tax rate when accessing wealth, preserving more for inheritance and highlighting how the benefits of a Tax-Smart SMA extend across multiple parts of a client’s lifecycle.

• Pro – Flexibility of owning individual stocks can provide benefits when transitioning assets, in ongoing loss harvesting and when accessing accounts for gifting or spending needs
• Con – Large number of positions to manage, diversification benefit may not be immediate

351 ETF exchanges

Exchanging individual securities for shares in an ETF allows investors to retain the cost basis of their contribution. No tax event occurs during the exchange itself, although the potential for one exists when shares of the ETF are ultimately sold.

These exchanges can be appealing to clients who would like to consolidate portfolios of many individual holdings within a brokerage account or an SMA (or even an older Tax-Smart SMA) into one single position or line item. However, clients should consider several potential trade-offs before taking this approach.

First, clients may take on additional risk or tracking error in a 351 exchange as their holdings are pooled with the holdings of other clients seeding the ETF. While the ETF will seek to transition over time to its own target strategy, this may not be instantaneous and the client may be swapping one kind of risk for another during the transition – for example, picking up exposure to different asset class, geographies or securities. Clients also need to accept the new ETF's investment strategy going forward.

In addition, many of the ETFs being launched to facilitate 351 exchanges operate with a higher cost or expense ratio than clients may experience in Tax-Smart SMAs.

Lastly, the positions used to fund a 351 exchange must themselves already be diversified. Therefore, this strategy would not be appropriate for clients with significant concentrated stock issues.

• Pro – Ability to consolidate to one single position in a tax-efficient manner, ability of ETF manager to manage capital gains within the fund
• Con – Potential for higher tracking error/active risk, potential for higher costs and regulatory requirements to meet diversification tests on initial exchange

Exchange Funds

In a key difference from 351 ETF exchanges, an investor can contribute a concentrated position into an exchange fund and receive immediate diversification benefits. The cost, however, is the illiquidity associated with the exchange fund: investors must typically hold shares of the fund for at least seven years. Additional risks associated with exchange funds include the requirement to invest at least 20% of the portfolio in qualifying illiquid assets (such as real estate) to meet the requirements for special tax treatment.

Lastly, these structures tend to be expensive and may have limitations on specific stocks they will accept. For example, if a fund already owns a significant amount of a particular stock, it may not be willing to take on more exposure to that stock because it would limit the fund’s ability to diversify assets across its investor base.

• Pro – Ability to consolidate to one single position in a tax-efficient manner, instant diversification of concentrated positions
• Con – Lost flexibility and potential tax advantages for a client who may want to gift or spend out of their account, cost, illiquidity and active risk associated with qualifying assets

Considerations for clients

Each option for moving from point A to point B in a tax-efficient manner comes with important considerations for clients. We believe that Tax-Smart SMAs offer many benefits, while acknowledging that they come with the complexity of many holdings or line items within a client portfolio. 351 ETF exchanges and exchange funds offer the benefits of simplified holdings albeit with the trade-offs of reduced flexibility, higher fees and additional risks.

Tax-managed investment strategies rarely offer “one size fits all” solutions and we would instead guide advisors to weigh the pros and cons of all paths.

¹ For transitioning accounts, a Tax-Smart SMA’s loss harvesting process involves seeking to harvest losses on a portion of the account and using those losses to offset gains associated with the sale of remaining legacy exposures. For fully transitioned accounts, the account can continue to tax loss harvest on an ongoing basis, with harvested losses now passed on and able to be used to offset gains elsewhere in the client’s portfolio