Exchange Privilege

Silvestra uses the exchange privilege to move 25,000 dollars from Ravelston Short Term Bond Fund into Ravelston Growth Fund, both in the same family, at net asset value. She is surprised to receive paperwork covering two transactions rather than one. Her representative should explain that:

1. A.The fund made an error and should have processed a single transfer of shares between the two portfolios.No error occurred. An exchange is always processed as a redemption followed by a purchase.
2. B.An exchange is processed as a redemption of the first fund and a purchase of the second, and in a taxable account the redemption leg is a reportable sale.Correct. The exchange privilege waives the sales charge but the transaction is still a redemption plus a purchase, and it is taxable.
3. C.The second document is a duplicate confirmation sent to her tax preparer as a courtesy.Both documents reflect the two legs of her own transaction, not a duplicate sent elsewhere.
4. D.Because no sales charge applied, the transaction is not reportable for tax purposes.The sales charge waiver has no bearing on taxation. The redemption leg produces gain or loss.

Why: An exchange is processed as a redemption of the first fund followed by a purchase of the second, so the confirmation reflects both legs. The exchange privilege waives a new sales charge within the family, but it does not change the mechanics: shares of the first fund are cancelled and shares of the second are issued, and in a taxable account the redemption leg is a reportable sale.

A fund-family exchange privilege lets an investor:

1. A.Switch tax-free between any fundsThe absence of a new sales charge makes the switch feel costless, and that is the misconception the privilege regularly creates. Selling one fund and buying another is a redemption for tax purposes, so gain or loss is realized on the shares given up, and the exchange is limited to funds within the same family.
2. B.Defer taxes indefinitelyIndefinite deferral is what an annuity or a retirement account provides, not what an exchange privilege does. Each exchange is a taxable disposition, so repeated switching accelerates the tax bill rather than postponing it.
3. C.Avoid all sales charges permanentlyThe privilege does waive a new load on the exchange itself, so the answer contains something real. The word permanently overreaches: the original purchase carried its charge, contingent deferred charges can still apply on an eventual redemption, and the fund may restrict the privilege to discourage frequent trading.
4. D.Switch funds in the same family at NAV, though it is taxableCorrect - exchange at NAV, but a taxable sale.

Why: An exchange privilege allows switching between funds in the same family at NAV, but it is still a taxable event.

Ottilie holds 60,000 dollars of Class A shares of Pemberton Growth Fund on which she paid a front-end sales charge. She now instructs her representative to move the entire position into Wexbury Balanced Fund, an unrelated fund family. Compared with an exchange inside the Pemberton family, this transaction:

1. A.Is treated as an exchange at net asset value, so no new sales charge applies but the gain is taxable.Exchange privileges operate only within one fund family. Moving to an unrelated family is not an exchange.
2. B.Avoids both a new sales charge and current taxation, because the proceeds are reinvested immediately.Immediate reinvestment does not defer tax in a taxable account, and a new sales charge does apply.
3. C.Is taxable and free of a new sales charge, because she already paid a front-end load in the Pemberton family.A load paid in one family gives no credit in another. The reinstatement privilege likewise applies only within a family.
4. D.Is a redemption followed by a separate purchase, so a full front-end sales charge applies to the new fund and the redemption is taxable.Correct. Across fund families there is no exchange privilege, so Ottilie pays a new sales charge and recognises gain or loss.

Why: An exchange privilege operates only within a single fund family and lets a shareholder move at net asset value without a new sales charge, although the exchange is still a taxable event. Moving to an unrelated family is not an exchange at all: it is a redemption of the first fund followed by a separate purchase of the second, so Ottilie pays a full front-end sales charge on the new fund and recognises gain or loss on the redemption.

A customer exchanges shares of a growth fund for shares of an income fund within the same fund family under the exchange privilege at NAV. For tax purposes, the exchange is:

1. A.Tax-free because both funds are in the same familyWrong. Family membership affects sales charges, not taxation.
2. B.Tax-free under IRC Section 1035Wrong. Sec. 1035 covers insurance and annuity contracts, not mutual fund exchanges.
3. C.A taxable event on which gain or loss is recognizedCorrect. The exchange is a disposition of the old shares for tax purposes.
4. D.Taxable only if completed within 30 days of the original purchaseWrong. The exchange is taxable regardless of timing; 30 days relates to the wash-sale window.

Why: Exchanging one fund for another, even within the same family and at NAV, is a redemption of one security and purchase of another, so capital gain or loss is recognized on the shares surrendered. Citation: IRC Sec. 1001 (realization on disposition). Takeaway: exchange privilege avoids a new sales charge, not taxes.