Section 351 ETF Exchange

Diversifying a portfolio while deferring capital gains.

For investors holding large positions of highly appreciated individual stocks that carry significant capital gains exposure, it can be hard to figure out a path towards diversification that does not include a large, immediate tax bill.

One strategy to address this situation is to perform a tax-deferred 351 ETF Exchange (also called a 351 ETF Conversion). With a 351 ETF Exchange, an investor is essentially transferring a designated portfolio of appreciated individual stock positions to a fund company in exchange for shares of a newly formed ETF (exchange traded fund). Each ETF is built around a specific investment strategy, so it's important to determine if that strategy aligns with your portfolio goals. Some ETFs are broadly diversified and track major indexes like the S&P 500, offering exposure to a wide range of stocks. Others are more narrowly focused, targeting specific sectors or themes, which may or may not suit your investment objectives. The 351 Exchange allows you to reduce concentration risk in your portfolio without generating an immediate tax bill.

Deferred Taxes on a 351 ETF Exchange

When you perform a 351 ETF Exchange you will not receive a tax bill for the capital gains associated with the individual positions that you transferred. Instead, the capital gains will be deferred until you sell your shares of the new ETF. The cost bases and holding periods of your original positions are preserved within the ETF.

Upon your death, the beneficiary inheriting your shares from the 351 ETF Exchange will benefit from a step-up in cost basis of the underlying shares, which can effectively eliminate any unrealized capital gains.

While a 351 ETF Exchange can be useful in some situations, it is not suitable for all investors and there are many considerations to keep in mind before executing a 351 ETF Exchange.

Eligibility for a tax-deferred 351 ETF Exchange requires meeting specific asset requirements:¹

• The total value of the portfolio being transferred typically needs to be $1 million or greater.
• No single holding can be greater than 25% of the total portfolio being transferred.
• The top five positions cannot make up more than 50% of the portfolio’s net asset value.

Liquidity Concerns

351 ETF Exchanges are relatively new. Currently, the available fund options have lower trading volume and higher associated costs than broad-based ETFs that track similar indices. Lower trading volume means it can be more difficult to enter and exit positions in these funds, and that the price of the ETF can be more volatile.

While not suitable for everyone, 351 ETF Exchanges can be a powerful tool for certain investors looking to add diversification while reducing concentration risk within their portfolio in a tax efficient way.

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1. "Using Section 351 Exchanges To Tax-Efficiently Reallocate Portfolios With Embedded Gains." Kitces.com. March 12, 2025