Got Cap Gains? How Portfolios Can Move Into ETFs Tax-Free

After nearly two decades of rising markets, you—like many investors—may be sitting on a portfolio brimming with unrealized capital gains. Great for your net worth. Terrible for your tax bill.

When the stock market appreciates considerably, long-term investors can counterintuitively find themselves frozen by their own success, unable to trim back or otherwise sell out of lucrative positions without triggering a major tax event. As a result, they’re de facto prevented from finding cheaper strategies, reducing portfolio concentration, or adjusting their asset allocation to fit their evolving goals and risk tolerance.

Enter the 351 ETF conversion. This nifty quirk of the IRS code allows investors to shift appreciated investments into an ETF structure without immediately triggering capital gains tax.

351 conversions are rapidly gaining attention as a deft way to maneuver the double-edged sword of success. According to Tax Alpha Insider’s Brent Sullivan, 82 351 ETFs have been seeded by individual investors with $16.6 billion of assets.

That might seem like a drop in the bucket now. So were ETF inflows, once upon a time.

What Is A 351 Conversion?

Originally designed to facilitate corporation formation, Section 351 has existed in the U.S. tax code for roughly a century.

The code allows for investors to contribute their property, such as stocks and ETFs, to a newly formed corporation as an in-kind exchange. (In-kind exchanges are transactions in which equivalent assets change hands without a sale taking place, i.e., shares for shares. You might recall in-kind exchanges as the backbone of ETF creation/redemption and what makes the structure so tax-friendly.)

Since most ETFs technically exist as “registered investment companies,” some issuers have begun adapting the 351 code to launch ETFs using securities. (Read More: “An Investor’s Field Guide to ETF Structures”)

Here’s how it works: An investor owns a stock portfolio in, say, a separately managed account. Those shares of stock are contributed to form a new ETF; in return, the investor receives the newly created ETF shares. The investor’s original cost basis carries over, and no capital gains are realized.

It’s important to note that the investor hasn’t eliminated their tax burden, just deferred it. But a 351 conversion enables investors to move assets into new strategies in a tax-efficient way. Over time, the ETF managers may be able to then offload stock shares with a lower cost basis via creation/redemption.

Why Are 351 Conversions Taking Off Now?

If Section 351 has been around for nearly a century, why are we only seeing 351 conversions take off now?

Essentially, three forces have converged to bring this strategy into prime time. First and foremost is the aforementioned market bull run. Since March 2008, the S&P 500 Index alone is up more than 1,000%—and other indices and individual assets are much higher. As such, investors that bought at all-time lows and held are now sitting on a massive tax bomb waiting to go off.

Granted, other methods have emerged over the years to reduce that tax burden. For example, in tax-loss harvesting, you sell an asset at a loss to balance out gains realized elsewhere in the portfolio, then you buy a similar (but not identical) security back to maintain a constant exposure. Especially if done on a regular basis, tax-loss harvesting can lower your securities’ cost basis so much that it becomes difficult to find losses to keep harvesting—particularly if the market keeps going up, which it has been doing for years.

Another important factor enabling 351 conversions is the simple fact that it’s now operationally possible to enact them.

In 2019, the SEC passed the ETF Rule, essentially making ETFs “real” in the eyes of the law. As part of this new ruleset, ETF issuers were given far greater flexibility in the use of custom baskets during ETF creation/redemption.

Before the ETF Rule, most issuers had to provide a strict pro rata slice of their portfolio when creating or redeeming shares. Custom baskets were rare and required special exemptive relief. After the ETF Rule, however, they gained greater freedom in which securities went into the creation basket, better enabling issuers to offload their lowest cost basis securities and making realistic tax management for a 351 ETF achievable.

The third big trend enabling 351 ETF conversions is the rise of ETF white label providers. More asset managers want to enter the ETF market than realistically can (or want to) DIY, and they’re all too happy to hand over the operational reins to an experienced third-party. Launching and managing an ETF is also expensive, especially from scratch. Using a white labeler can streamline the process, since the company can just launch new ETFs from their already existing trusts.

Who Is a 351 Conversion Good For?

Unfortunately, not every investor with a juiced up portfolio can enact a 351 conversion. To be eligible, a portfolio must meet certain conditions (including the same diversification rules that apply to any other registered investment company):

No single security can exceed 25% of the portfolio

The top 5 stocks can’t exceed 50% of the portfolio’s value

In addition, only equities, ETFs, and ADRs can be used in a 351 conversion. Mutual funds, crypto, options, private equity, and other alternatives are not eligible.

In other words, investors can’t simply hotswap an 80% NVDA /20% VOO portfolio for an ETF and call it a day. (That said, the IRS doesn’t consider an ETF held by an ETF to be a single security, but rather a package of all the securities it contains. So if the 351 ETF holds shares of VOO, the IRS would consider that position to be equivalent to the constituent 519 stocks, held in their proper proportions.)

As such, 351 conversions make the most sense for investors whose portfolios are diversified already, but which contain sizable embedded gains or an extremely low cost-basis. Highly concentrated portfolios are still doable in a 351 conversion, but generally you can only convert part of the concentrated position, not all.

There Is No Free Lunch

It’s important to remember that a 351 exchange is not a magic wand that makes taxes go away forever. Your tax burden is deferred, but not eliminated entirely. As soon as you sell your ETF shares, a tax event may trigger.

What’s more, implementation takes time. The new ETF requires investors to hold onto the shares for some period, because the IRS will scrutinize whether or not this conversion was a pre-arranged tax dodge. Meaning, you’re committed; you can’t simply dump the new ETF shares immediately after receiving them.

That’s to say nothing of the fact that the portfolio transition itself usually takes months, during which time there may be tracking differences that emerge between the old portfolio and the new.

Are 351 ETFs The Next Major ETF Frontier?

Still, 351 conversions are gaining steam. Over the past few decades, ETF growth has come from mutual fund to ETF conversions, active ETF launches, and product evolutions like options income funds and crypto ETFs. 351 conversions have the potential to swamp them all, for the simple fact that investors hate paying taxes if they don’t absolutely have to.

With trillions of dollars sitting in tax-constrained portfolios, a vast reservoir of investor assets already waits behind the dam. 351 conversions could be the channel that finally lets them flow.