After years of robust stock market growth, many investors find themselves sitting on substantial unrealized gains in taxable accounts—a scenario ripe for a hefty capital gains tax bill once those assets are sold. For high-net-worth individuals, this tax bite can be particularly severe, with top federal capital gains rates hitting 20%, plus an additional 3.8% net investment income tax depending on income levels. But savvy investors and advisors are increasingly turning to a lesser-known, yet powerful strategy to defer these taxes: the 351 conversion or exchange.
What Is a 351 Conversion and Why Should Investors Care?
Named after Section 351 of the IRS code, this tax strategy allows investors to transfer appreciated securities into a newly launched exchange-traded fund (ETF) without immediately triggering capital gains taxes. Essentially, investors contribute their appreciated assets to seed an ETF before it goes public, receiving shares in return. Capital gains taxes are deferred until those ETF shares are sold, offering a tax-efficient way to reposition portfolios.
Certified Financial Planner David Haas of Cereus Financial Advisors describes this method as “like magic” for certain clients, and it’s easy to see why. Unlike traditional mutual funds or separately managed accounts (SMAs), ETFs structured this way can accept assets pre-launch and rebalance internally without generating taxable events.
Why Now? The Growing Relevance Amid Market Maturity
For years, SMAs have been a favored vehicle for high-net-worth investors due to their customization and tax-loss harvesting capabilities. However, as Morningstar analyst Daniel Sotiroff points out, tax-loss harvesting opportunities naturally diminish over time as portfolios grow and gain value. Eventually, investors face fewer chances to offset gains with losses, and changing investments often triggers capital gains.
This is where 351 conversions come in as a timely solution. Large financial firms have long used private ETFs seeded through these exchanges, but now smaller firms and even individual SMAs are gaining access to publicly seeded 351 ETFs. The trend is nascent but growing, with industry experts predicting more launches in the near future.
Key Considerations and Limitations Investors Must Know
While the tax deferral benefits are appealing, 351 conversions come with strict rules and caveats:
- Diversification Requirements: To qualify for tax deferral, the contributed assets must be diversified. No single stock can exceed 25% of the contributed assets, and the top five holdings must not exceed 50%. This means you can’t just transfer a single highly appreciated stock and expect to defer taxes.
- Asset Restrictions: Certain asset types, such as mutual funds, private equity, or cryptocurrencies, may not be eligible for contribution.
- High Minimum Investments: Currently, minimum investments remain steep. For example, Alpha Architect’s 351 ETF conversion requires a $1 million minimum, and Cambria Funds’ upcoming 351 ETF launch in December 2024 also sets a $1 million entry point.
The “Stuck Money” Dilemma: What Advisors and Investors Should Watch Out For
One critical downside, often overlooked, is liquidity and flexibility. When you exchange assets for ETF shares via a 351 conversion, you are effectively “locked in” to that ETF’s structure and holdings. CFP Charles Sachs of Imperio Wealth Advisors warns that this can limit clients’ options, as exiting the position without triggering capital gains can be challenging. While theoretically, you could perform another 351 exchange to move into a different ETF, few firms currently offer this service, making it a risky bet on the ETF’s long-term suitability.
What This Means for Investors and Advisors: Actionable Insights
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Evaluate Your Tax Position and Portfolio Growth Trajectory: Investors with large unrealized gains in taxable accounts should assess whether their current tax-loss harvesting strategies are nearing exhaustion. If so, exploring 351 conversions could be a strategic move to defer taxes while maintaining market exposure.
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Prioritize Diversification and Alignment: Since 351 conversions require diversified contributions, investors must ensure their portfolios meet these criteria before initiating a conversion. Additionally, because you’re effectively committing to the ETF’s holdings, it’s crucial to evaluate the ETF’s investment philosophy and management.
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Prepare for Illiquidity: Advisors must counsel clients on the potential “lock-in” effect. If flexibility is paramount, 351 conversions may not be suitable. However, for long-term, tax-efficient wealth transfer or estate planning, this strategy can be a game-changer.
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Watch for Emerging Players and Lower Minimums: The $1 million minimum is a barrier for many, but the ETF space is evolving rapidly. Keep an eye on new entrants and innovations that could lower these thresholds, democratizing access to 351 conversions.
What’s Next? Forecast and Industry Trends
Given the rising capital gains tax discussions at the federal level and increasing market volatility, tax-efficient strategies like 351 conversions are poised to gain traction. Morningstar and other research firms forecast a gradual increase in the number of 351 ETFs launched, potentially expanding beyond the ultra-wealthy to a broader investor base.
Moreover, technology platforms and financial advisors are likely to develop more streamlined processes to facilitate these exchanges, possibly integrating them with automated portfolio management tools. This could transform 351 conversions from a niche tactic to a mainstream tax strategy within the next five years.
Unique Insight: A Real-World Example
Consider a hypothetical investor, Jane, who holds $2 million in a high-growth tech stock within her SMA. She’s nearing the point where tax-loss harvesting is no longer effective. By seeding a newly launched 351 ETF with her appreciated stock, Jane defers an estimated $400,000 in capital gains taxes (assuming a 23.8% combined tax rate). Over the next decade, this deferred tax capital can be reinvested and compounded, potentially adding hundreds of thousands of dollars in after-tax wealth compared to selling outright today.
In conclusion, 351 conversions represent a sophisticated, yet underutilized, tax strategy that can provide significant benefits for high-net-worth investors grappling with large unrealized gains. However, this is not a one-size-fits-all solution. Investors and advisors must weigh the trade-offs carefully, considering diversification rules, liquidity constraints, and minimum investment requirements. For those who qualify and have a long-term horizon, 351 conversions could be a powerful tool to enhance after-tax returns and preserve wealth.
Stay tuned as we track this evolving space and bring you the latest insights to help you stay ahead in tax-efficient investing.
Source: How wealthy investors use ETFs to avoid capital gains taxes