Exchange Fund Rules:
The 7-Year Hold and the 80/20 Test

Which two rules define an exchange fund?

Contributing property to a partnership is normally tax-free under §721(a). The exceptions and anti-abuse rules around that sentence are what turn an exchange fund into a seven-year, 80/20 vehicle.

What is the 80/20 investment company test?

§721(b) switches off nonrecognition when property goes into a partnership that would be an "investment company" if it were a corporation, borrowing the test from §351(e) and Treasury Regulation §1.351-1(c). Broadly, a transfer is taxable if (1) it results in diversification of the transferors' interests and (2) more than 80% of the entity's assets held for investment are readily marketable stocks or securities.

An exchange fund exists to diversify you, so it cannot avoid condition (1). It avoids condition (2) instead, by holding at least 20% of its assets in something that is not a marketable security. Sponsors usually choose real estate, often through private partnerships and often financed with debt. Sponsor materials note that publicly traded REIT shares generally do not count toward the sleeve.

Where does the seven-year rule come from?

Partnership law has two anti-abuse rules aimed at exactly what an exchange fund does: putting in one asset and taking out a different one.

Both windows close seven years after contribution (for property contributed after June 8, 1997). That is why a diversified distribution waits until year seven, and why early exits usually return your own shares: getting back the property you put in doesn't trigger either rule.

How do you get the diversified basket out without tax?

One more hurdle: under §731(c), a partnership distribution of marketable securities is generally treated like a distribution of cash, which can be taxable. An exception for qualifying investment partnerships covers partners who contributed only securities and similar assets. Exchange funds are built to fit that exception, which is what lets the basket come out without tax.

Your basis in the basket is generally your basis in the partnership interest, allocated across the securities you receive (§732(b)). The low basis comes with you. See Exiting an Exchange Fund for the math.

What happens in each year of an exchange fund?

Does a §721 SPV like Embark have a seven-year clock?

An SPV that holds your own stock's economics does not diversify you, so it is not trying to pass the 80/20 test and doesn't need a mixed basket to come out. Embark's lock-up is three years, after which you can stay and keep earning or exit and receive your shares back. The structure is covered in What Is a Section 721 Contribution Strategy?.

Frequently asked questions

Why do exchange funds have to hold real estate?
To avoid the §721(b) investment-company exception. If more than 80% of the fund's investment assets were marketable stocks and securities and the transfer diversified investors, contributions would be taxable. Holding 20% or more in non-securities such as real estate keeps the fund outside that test.

Where does the seven-year rule come from?
From the partnership mixing-bowl rules in IRC §704(c)(1)(B) and §737. Both can trigger your pre-contribution gain if contributed property moves between partners, or you receive other property, within seven years of contributing.

Can I leave an exchange fund before seven years?
Usually only by taking back the shares you contributed, which avoids triggering gain but gives up the diversification. Some funds also charge early-redemption fees.

Do the seven years reset if I add more stock?
Each contribution generally has its own seven-year window for that property. Ask the sponsor how additional contributions are tracked.

What is the 80% test for exchange funds?
Under IRC §721(b) and the investment company rules in Treas. Reg. §1.351-1(c), a partnership is treated as an investment company if more than 80% of its assets are stocks and securities held for investment, and diversifying contributions to it would be taxable. Exchange funds keep at least 20% in qualifying illiquid assets to stay under that line.

Was the exchange fund holding period always seven years?
No. Congress lengthened the mixing-bowl period from five years to seven years in 1997, which is why older articles mention five years.

Does the seven-year clock apply to Embark?
Embark's SPV does not pool investors' stocks into a shared basket, so it does not rely on the seven-year mixing-bowl window. Its terms include a 3-year lock-up, after which you get your own shares back.

Statutes and regulations