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Selling stock at a profit generates capital gains taxes. If you have a large amount of a single stock and want to diversify, a swap fund allows you to do that without incurring this tax.

Much of the capital gains tax is simply paying tax on government-induced inflation. Every month, until it finally stopped this fall, the Federal Reserve injected billions into the money supply. This devaluation of our currency causes inflation that naturally pushes all prices, including stock prices, higher. When stock appreciates, even just due to inflation, it accumulates unrealized capital gains. You pay the capital gains tax when you sell.

The capital gains tax can hit investors hard. If the government causes 4.5 percent inflation, taxpayers in the 23.8 percent capital gains tax bracket have to earn at least 9.24 percent for 10 years just to maintain the value they originally put into the market and break even.

We previously explained 14 ways to avoid paying capital gains. When a person dies, the heirs typically pay no taxes on the inherited investment gains, as they receive a step-up in cost basis (the base price used to calculate appreciation) to the current share price. If mom bought a company's stock for $1 per share in 1985 and it now is $10, her son's tax liability is figured on anything above $10, not above $1.

Another technique is a share exchange, sometimes called a swap fund. Stockholders can diversify their portfolios without paying capital gains tax. It is normally an expensive service. For average investors, this is an option they never need to explore.

Consider Stanley, an investor with $5 million in a single publicly traded company. Stanley's grandfather started the company and then brought it public, giving him the lowest basis possible. When Stanley became a corporate executive in the company, he received, both as a gift and as stock options, some of that low-basis stock. Now his stock faces almost $1.2 million in capital gains taxes if he decides to sell.

Stanley can join a fund created specifically to assist investors with highly appreciated stock. He can exchange his $5 million worth of stock for an equivalent value of shares in the newly created fund.

The Internal Revenue Service says the fund must have at least 20 percent of its value composed of non-publicly traded assets such as private companies, limited partnerships or real estate. The exchange fund also needs to run for at least seven years before Stanley can sell any of the investments in the fund.

However, if he does, he still owes a sizable capital gains tax. What this method does is diversification without capital gains tax, not liquidation. With the share exchange, Stanley can diversify his investments while delaying the realization of any capital gains. He exchanges stock in a single highly volatile company for a collection of roughly diversified assets.

This diversification may protect Stanley's retirement fund from large fluctuations, giving him a safer ride into retirement. Once he is retired with a lower income and tax bracket, he may be able to sell pieces of his portfolio without as much of a penalty.

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