ETF industry exploits tax loophole, costing US Treasury $48 billion annually
In brief
- ETFs exploit Section 852(b)(6) to avoid capital gains taxes through in-kind redemptions to major investment banks.
- Heartbeat trades—choreographed deposits and redemptions—flush appreciated securities without triggering taxable events.
- Wealthy Americans benefit most, holding more financial assets and facing higher capital gains tax brackets.
The Heartbeat Trade Mechanism
Bloomberg's reporting highlights a technique known as heartbeat trades, where authorized participants deposit cash into an ETF and quickly redeem shares in-kind to flush appreciated securities out of the fund. These aren't organic market transactions. They're choreographed moves designed purely to eliminate tax liabilities. The result: the fund offloads its highest-gain holdings without ever recognizing them as a taxable sale.
ETFs hand those stocks directly to large institutional players, who can then realize gains on their own terms or hold indefinitely. The mechanism is legal but has exploded in scale. Bloomberg previously estimated in 2019 that around $23 billion in taxes were being deferred through these mechanisms. The current figure has more than doubled in just seven years.
A Staggering Cost to Public Coffers
The $48 billion in annual lost revenue is roughly enough to fund the entire budget of the Department of Homeland Security. Since 2019, approximately $211 billion in capital gains have been avoided across major equity ETFs, according to prior Bloomberg analysis.
The burden falls unequally. The beneficiaries are overwhelmingly the wealthiest Americans, with the top 1% of income earners capturing the largest share of tax savings. Wealthier households hold disproportionately more financial assets, including ETFs, and they're in higher tax brackets where capital gains deferral delivers the biggest advantage.
Scope and Implications
Bloomberg's investigation did not include cryptocurrency or digital asset ETFs in its scope. The relatively recent arrival of spot Bitcoin and Ether ETFs means those products haven't yet accumulated the same magnitude of unrealized gains as traditional equity ETFs. As these crypto funds mature and accumulate appreciated positions, the same tax deferral mechanics could amplify losses to the Treasury further.
