ETFs avoid capital gains taxes at the fund level through in-kind redemptions: instead of selling securities for cash to meet withdrawals, the fund hands the actual shares over to a large broker-dealer, and the tax code treats that transfer as a non-taxable event. The result shows up clearly in the numbers. In 2025, only 7% of U.S. ETFs paid any capital gains distribution, compared with 52% of mutual funds.1State Street Investment Management. Tax Efficiency Is Structural: ETFs Continue to Issue Fewer Capital Gains Than Mutual Funds The mechanism has real limits, and it doesn’t erase your own tax bill when you sell.
The In-Kind Redemption Mechanism
A traditional fund raising cash for withdrawals sells stocks or bonds, locks in gains, and passes those gains through to every remaining shareholder as a year-end distribution. ETFs take a different route. When redemptions happen at the fund level, the ETF delivers the underlying securities directly to the party requesting them. There’s no sale, so there’s no taxable gain inside the fund.
The legal foundation is Section 852(b)(6) of the Internal Revenue Code, which blocks the gain-recognition rules that would otherwise apply when a regulated investment company distributes property. Because the statute exempts these transfers from gain recognition, the fund can hand off deeply appreciated shares without recording a taxable event.2Office of the Law Revision Counsel. 26 U.S. Code 852 – Taxation of Regulated Investment Companies
Managers make the shield sharper by choosing which lots go out the door. When a redemption is being filled, they typically send out the shares with the lowest original cost basis, meaning the ones sitting on the biggest unrealized gains. Those embedded gains leave the portfolio entirely. The holdings that stay behind carry a higher average cost basis, which means smaller gains if they’re ever sold for cash later.
Who Actually Does the Swap
Ordinary investors never touch this process. In-kind redemptions happen only between the ETF and a small group of large institutional firms called Authorized Participants, generally major broker-dealers operating under a formal agreement with the fund issuer.3Schwab Asset Management. Understanding the ETF Creation and Redemption Mechanism They transact in blocks called creation units, usually 25,000 to 50,000 ETF shares.4State Street Investment Management. How ETFs Are Created and Redeemed
The process runs in both directions. To create shares, an AP delivers a basket of the underlying securities to the ETF and receives newly minted shares in return. To redeem, the AP returns a creation unit of ETF shares and takes back the underlying securities. The redemption leg is where the tax benefit sits, because that’s when appreciated positions leave the fund without a sale.
When you sell your ETF shares in your brokerage account, none of this touches the fund’s holdings. You’re selling to another investor on the exchange. The fund’s portfolio only moves when an AP creates or redeems a creation unit.
Why Mutual Funds Can’t Do This
Mutual funds are structurally locked out. When you sell mutual fund shares, you’re transacting with the fund company itself, and the fund must raise cash internally to pay you. In a wave of redemptions, the manager sells securities to generate that cash and locks in gains on whatever gets sold.5Vanguard. How Mutual Funds and ETFs Are Taxed Those gains flow through to every shareholder who’s still in the fund at year end, regardless of whether they personally sold anything or even had a losing year.
The distribution gap has held for years. From 2016 through 2025, 53% of mutual funds distributed capital gains annually versus just 9% of ETFs.1State Street Investment Management. Tax Efficiency Is Structural: ETFs Continue to Issue Fewer Capital Gains Than Mutual Funds The spread is widest for equity funds, where in-kind delivery is easiest to execute.
Custom Baskets and Heartbeat Trades
SEC Rule 6c-11, adopted in 2019, lets ETFs use custom baskets in creation and redemption transactions. A custom basket doesn’t have to mirror the fund’s overall holdings proportionally. The manager can fill it with whichever securities serve the fund’s interests, provided the fund has adopted written policies governing how the baskets are put together.6eCFR. 17 CFR 270.6c-11 – Exchange-Traded Funds Before the rule, most ETFs operated under individual SEC exemptive orders that generally required baskets to reflect the portfolio on a pro-rata basis.7U.S. Securities and Exchange Commission. Exchange-Traded Funds Final Rule
In practice, when an index changes and the fund needs to swap out a component, the manager can load the departing stock into a redemption basket and deliver it to the AP tax-free, even if that stock has tripled in value since purchase. The fund gets the new index component in, the appreciated one out, and no gain is recorded.
Some managers push the tactic further with what the industry calls heartbeat trades. An AP contributes a large block of securities to the fund in exchange for new ETF shares, then redeems those same shares a day or two later. On the way out, the fund delivers a custom basket loaded with its most appreciated holdings. Graphed as daily flows, the paired spikes resemble a heartbeat.
The economic substance is thin. The AP isn’t making a long-term investment; it’s providing the round-trip that creates the legal framework for an in-kind distribution of embedded gains. Tax scholars have criticized the practice as stretching Section 852(b)(6) beyond its intended purpose, and traditional doctrines like step transaction or business purpose could theoretically collapse the two legs into a single taxable exchange. The IRS has not challenged heartbeat trades directly to date, but the legal risk isn’t zero.
Where the Shield Doesn’t Hold
In-kind redemptions don’t work equally well across every kind of ETF. Fixed-income ETFs distributed capital gains at nearly four times the rate of equity ETFs in 2025, 23% versus 6%.1State Street Investment Management. Tax Efficiency Is Structural: ETFs Continue to Issue Fewer Capital Gains Than Mutual Funds Certain bond types, including mortgage-backed securities, asset-backed securities, and collateralized loan obligations, are difficult or impossible to transfer in-kind, so the fund has to sell them for cash and take the gain.8J.P. Morgan Asset Management. Tax Efficiency of ETFs
Commodity ETFs structured as partnerships holding futures contracts operate under different rules altogether. Gains are taxed annually at a blended rate, 60% long-term and 40% short-term, whether or not the fund distributes anything. Investors receive a Schedule K-1 and owe taxes on their share of gains each year even if they never sold a share.9Fidelity Investments. Rules for Commodity ETFs
Some markets, including Brazil, China, and India, don’t allow locally listed securities to change hands in-kind.8J.P. Morgan Asset Management. Tax Efficiency of ETFs ETFs holding positions in those markets often have to sell for cash when rebalancing. Actively managed funds with high turnover face a similar problem: the more the fund trades, the harder it is to offset every gain through in-kind redemptions.
You Still Owe Taxes When You Sell
The in-kind mechanism keeps gains out of the fund. It doesn’t keep them off your return. When you sell ETF shares for more than you paid, you owe capital gains tax on the difference. Shares held longer than a year are taxed at long-term rates of 0%, 15%, or 20% depending on income; shares held a year or less are taxed as short-term gains at ordinary rates, which can reach 37%.
High earners also face the 3.8% net investment income tax on gains when modified adjusted gross income exceeds $200,000 (single) or $250,000 (joint), bringing the top effective rate on ETF sales to 23.8%.10Internal Revenue Service. Topic No. 559, Net Investment Income Tax
Dividends are their own line. Qualified dividends from equity ETFs are taxed at long-term capital gains rates, but interest income from bond ETFs is taxed as ordinary income. Reinvested dividends are still taxable in the year you receive them, even though the money goes straight back into more shares.11Internal Revenue Service. Stocks (Options, Splits, Traders) 2 The fund’s tax efficiency is real, but it’s a shield for what happens inside the fund, not for what happens on your 1099 when you cash out.