The rule says that a fund can avoid recognizing taxable gains on an appreciated stock if the shares are used to pay off a withdrawing investor. The rule applies to both ETFs and mutual funds, but mutual funds rarely take advantage of it because their investors almost always want cash.
ETFs use it all the time, because they don’t transact directly with regular investors. Instead, they deal with Wall Street middlemen such as banks and market makers. It’s those firms, not retail investors, that expand the ETF by depositing assets or shrink it by withdrawing. These transactions are usually done with stocks rather than cash. The middlemen, in turn, trade with regular investors who want to buy and sell ETF shares.
Trading with middlemen presents ETFs a tax-cutting opportunity. Whenever one of these firms makes a withdrawal request, an ETF can deliver its oldest, most appreciated stocks, the ones most likely to generate a tax bill someday.
If the ETF wants to cut its taxes further, it can generate extra withdrawals just to harvest the tax break. A heartbeat is when an ETF asks a friendly bank or market maker to deposit some stock in the fund for a day or two, then take different stock out. Some critics call these trades an abuse of the tax code. But with the help of heartbeats, most stock ETFs, even ones that change holdings frequently, are able to cut their capital-gains taxes to zero.
