Yet Another Tax Benefit to ETF Investing with Section 351 Conversions

Matt Bucklin
3 min read5 days ago

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Investors often struggle with a large part of their portfolio tied up in unrealized gains, making it hard to rebalance without paying hefty taxes. Luckily, Section 351 of the Internal Revenue Code provides a way out. This rule allows you to contribute appreciated assets to a new Exchange-Traded Fund (ETF) in exchange for shares of the ETF without triggering taxes. This process is called a 351 tax-free conversion, helping investors defer taxes and enjoy the benefits of ETFs.

What Is a 351 Tax-Free Exchange?

A 351 tax-free exchange lets you transfer assets like stocks to a corporation, such as an ETF, and receive ETF shares without paying taxes at that time. The tax basis and holding period of your original assets carry over to the new ETF shares, letting you start an ETF with your existing investments. It's similar to a 1031 exchange used in real estate but for public securities.

Key Requirements for a 351 Conversion

To successfully convert, certain conditions must be met:

  • Diversification: Your contributed portfolio must meet diversification rules. No single position can be more than 25% of the portfolio's total value, and those over 5% can't collectively exceed 50%. The portfolio must have at least 12 different securities.
  • Control: After the exchange, investors must control at least 80% of the ETF's voting power and value.
  • Record-Keeping: Maintain accurate records of the cost basis and purchase dates of all positions.
  • Alignment: The contributed assets must align with the ETF’s investment strategy.

Benefits of Converting to an ETF

Switching a Separately Managed Account (SMA) to an ETF via a 351 exchange brings numerous advantages:

  • Tax Efficiency: Defers capital gains taxes, allowing your investments to grow tax-free until you sell the ETF shares, no K-1s!
  • Operational Simplicity: ETFs offer benefits like intraday liquidity, daily transparency, and streamlined reporting.
  • Lower Costs: ETFs usually have lower costs compared to SMAs, private funds, and mutual funds.
  • Access to Complex Investments: ETFs can more easily access complex investment instruments like derivatives and foreign securities.
  • Improved Diversification: Achieve a more diversified portfolio.
  • Professional Oversight: Enjoy professional management.
  • Trading Flexibility: Utilize trading techniques like limit orders and short sales.

Understanding ETF Tax Advantage

ETFs are tax-efficient due to their unique in-kind creation and redemption process. Instead of selling underlying assets, authorized participants (APs) redeem ETF shares for the underlying securities. This process avoids taxable gains at the fund level, and ETFs can select the lowest tax basis shares to minimize tax burdens.

Important Considerations

While 351 conversions are powerful, consider the following:

  • Client Permission: SMA investors must approve the conversion.
  • Custodial Transfers: In-kind transfers can be time-consuming.
  • Assets Under Management (AUM): Ensure enough assets in the strategy for a worthwhile transaction.
  • Economic Substance: The transaction must have real economic substance, not just a tax-reduction tactic.
  • Avoidance vs. Deferral: ETFs can only defer taxes on gains through in-kind redemptions, not avoid them forever and the cost basis doesn’t reset.

Finding ETF Opportunities with 351 Conversion

Resources like ETF Architect can assist with converting SMAs to ETFs. It's crucial to seek professional financial and tax advice before proceeding.

Conclusion

A 351 tax-free exchange helps diversify portfolios, defer taxes, and benefit from ETFs. However, it's a complex transaction with specific requirements. Carefully evaluate your situation and seek expert guidance. If you would like to get matched up with new ETF issuances that meet your investment criteria visit 351Conversion.com.

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Matt Bucklin
Matt Bucklin

Written by Matt Bucklin

President Credible. Principal Valley Cove Capital. Founder & CEO The Quit Company, Co-Founder Sense Relief, MBA Yale School of Management, BA Colby College.

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