Investors with large, highly appreciated stock positions can face a challenge: how to diversify those holdings without triggering a large capital gains tax bill.
Enter Section 351 exchanges.
Instead of selling an already diversified basket of appreciated securities, qualifying investors can contribute those holdings to seed a newly created ETF and receive ETF shares in return, deferring capital gains taxes.
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more – straight to your e-mail.
Profit and prosper with the best of expert advice – straight to your e-mail.
Not surprisingly, the strategy has attracted interest from some wealth managers, ETF sponsors, and investors. But as the transactions become more popular, they are also attracting federal government attention.
U.S. Treasury Department officials have recently identified Section 351 transactions as one of several tax-focused investment strategies under review.
So how does this exchange work, and why has it become a closely watched approach?
What is an IRS Section 351 exchange?
This ETF exchange strategy gets its name from Section 351 of the Internal Revenue Code, which generally allows investors to transfer property to a corporation without immediately recognizing gain if certain strict requirements are met.
In a Section 351 ETF transaction, investors contribute appreciated securities during the initial launch phase of a new exchange-traded fund.
Note: Because IRS rules require the initial contributor (or group of contributors) to own at least 80% of the new ETF’s total shares immediately after the exchange, this strategy cannot be used with existing, established ETFs. It is an opportunity that only occurs during the launch/seeding phase of a new fund.
- Instead of selling their holdings and receiving cash, which could trigger capital gains taxes in the year of the sale, investors receive shares of the ETF.
- If the transaction qualifies under Section 351, investors generally don’t recognize the involved capital gains at the time of the exchange.
It’s important to note that the tax benefit is a deferral, not a permanent elimination of tax. Investors’ built-in gain generally carries over to the ETF shares and may become taxable when those shares are sold.
For example: Consider an investor who holds a broad, diversified portfolio of 30 different stocks worth $1 million, with an original purchase price of $200,000 — meaning there is an $800,000 unrealized capital gain.
No single stock makes up more than 25% of the portfolio.
Selling all 30 stocks to buy a traditional ETF would trigger an immediate tax bill on the $800,000 gain. So, the investor contributes their entire diversified stock portfolio as part of the launch of a new ETF, following all applicable IRS rules.
In exchange, they receive shares of the ETF. Because the contributed portfolio was already diversified before the transfer, the investor generally defers the $800,000 gain via the qualifying Section 351 exchange.
Note: The above is a highly simplified example. Every investor’s situation is different, and you should consult a trusted tax advisor for guidance tailored to your financial circumstances.
Why some investors are turning to 351 ETFs
For some, the appeal of a 351 exchange is fairly straightforward: diversification without an immediate capital gains tax bill.
- Large stock positions can develop for many reasons, including years of investing, executive compensation, business ownership, or inherited assets.
- As mentioned, for investors with substantial unrealized gains, selling a position that has appreciated significantly can create a major tax liability.
Some supporters of the strategy argue that Section 351 exchanges represent legitimate tax planning within existing rules. They emphasize that investors aren’t eliminating tax liability for the gains; they are merely changing the timing of when those gains are recognized.
The table below highlights some key differences between selling appreciated assets, in this case, stock, and a qualifying 351 ETF transaction.
Selling Stock vs. Using a Qualifying 351 ETF Exchange
|
Feature |
Sell Appreciated Stock |
Use a Qualifying 351 ETF Exchange |
|
Portfolio Prerequisite |
Any single stock or portfolio structure |
Must be pre-diversified (no single stock >25%, top 5 >50% of total) |
|
Timing & Availability |
Anytime on the open market |
Limited Window: Only available during the initial launch phase of a newly created ETF |
|
Ownership Requirement |
None |
Contributing group must collectively own at least 80% of the new ETF immediately after creation |
|
Transaction Mechanics |
Investor sells holdings on the market and receives cash |
Investor contributes a diversified stock basket in-kind during the ETF’s launch |
|
Tax Impact |
Capital gains are recognized immediately in the tax year of sale |
Capital gains are deferred until the new ETF shares are eventually sold |
|
Primary Goal |
Cash out or exit a position |
Upgrade an existing multi-stock portfolio into a lower-cost, tax-efficient ETF |
| Row 7 – Cell 0 | Row 7 – Cell 1 | Row 7 – Cell 2 |
Why Treasury is taking a closer look
Meanwhile, Treasury Department officials’ recent comments highlight growing attention toward investment strategies designed around tax deferral.
Officials at a Wall Street Tax Association seminar reportedly said the agency is reviewing several tax-focused transactions, including Section 351 ETF structures, to determine whether certain arrangements could lead to abusive tax outcomes.
According to Bloomberg News, Kevin Salinger, Treasury’s deputy assistant secretary for tax policy, said: “We’re not here to be over-broad or disruptive, but we are also not prepared to turn the blind eye to aggressive planning.”
The concern is not necessarily that every Section 351 ETF transaction is improper. Rather, Treasury seems to be considering whether some structures achieve results that Congress didn’t intend when it created the underlying tax legislation.
351 exchange ETFs: What happens next?
Keep in mind: Treasury has not announced that Section 351 ETF transactions are prohibited, nor has it issued guidance, new restrictions, or enforcement actions regarding the tax treatment of qualifying exchanges.
So, for now, the strategy remains available for investors who meet the IRS requirements.
Still, the debate over 351 ETFs reflects a broader question in tax policy: How far can investors go in using existing rules to reduce or postpone tax bills before regulators decide the strategy has gone too far? Stay tuned.