Investing is one of the most effective ways to build wealth, but with investment gains come the inevitable: taxes.
Minimizing taxes on your investments can help you build wealth more effectively by keeping your money working for you for longer. Typically, you pay taxes on your investments when you receive dividends or sell your investments for a profit. Even selling a security and reinvesting the proceeds in another one can trigger a taxable event.
But 351 exchanges offer an option for investors who want to change up their investment portfolio without triggering a taxable event, letting them keep money in the market for longer.
How 351 Exchanges Work
A 351 exchange, so called because they are described in section 351 of the US code, lets investors move money from one investment to another without triggering a taxable event. This only applies in specific cases.
The code says,
“No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation.”
Put more simply, 351 exchanges allow investors to trade some of their securities to an investment company in exchange for shares in a newly formed ETF. This means you can avoid paying capital gains taxes on your gains while converting your existing portfolio into an ETF that may be more diversified.
The securities contributed by each person conducting a 351 exchange act as the seed funds for the ETF as it forms. You get shares in the ETF in proportion to the value of the securities you contribute, and the ETF managers may then hold those securities or do some rebalancing to reach the desired asset allocation.
More information here:
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Rules for a 351 Exchange
Investors need to follow a few rules when conducting a 351 exchange.
- You must contribute a diversified portfolio to the new ETF. This is defined as a portfolio with no more than 25% of its value in a single security and no more than 50% in five or fewer securities.
- Your contributions must align with the ETF’s strategy mandate.
- The contribution must be made before the ETF forms.
For example, if you have a portfolio with 20 different securities, each weighted equally, you could make a 351 exchange. If your portfolio is composed of 30% NVDA stock; 15% AMD stock; 10% each of Intel, Tesla, and Amazon stock; and 25% other miscellaneous shares, you wouldn’t be eligible due to the diversification rule.
Typically, investment companies will solicit investors looking to conduct 351 exchanges, with funding happening two or three months before the ETF forms.
Benefits of 351 Exchanges
There are two major benefits to 351 exchanges.
One is diversification. You can convert your portfolio into shares in an ETF that may be more diversified than your current holdings. That can help reduce some of your investment risk.
The main benefit, however, is deferring taxes on your investments while doing that rebalancing. Typically, if you wanted to diversify your portfolio, you’d need to sell some shares at a profit, triggering capital gains taxes. 351 exchanges avoid that entirely.
Imagine you have a portfolio that you want to diversify, but you have $100,000 in long-term capital gains that you’d recognize by selling your shares. That could trigger a tax bill as high as $20,000. If you conduct a 351 exchange, you get to keep that $20,000 invested. Assuming 7% real returns over the course of 30 years, that $20,000 could grow to more than $114,000, making a significant difference in your portfolio.
Drawbacks and Risks of 351 Exchanges
351 exchanges aren’t right for everyone.
For one, your portfolio needs to meet a number of requirements to qualify. 351 exchanges are great for diversifying your investments, but you already need to be somewhat diversified.
You also need to find a newly forming ETF that has an investment plan that is roughly aligned with the construction of your current portfolio. Some investment companies solicit investors looking to conduct 351 exchanges, which can make it easier to find matching opportunities. But you also have to consider fees, both for facilitating the exchange and ETF management, which may impact the tax savings.
Finally, there may be some tax and legal risks. 351 exchanges for asset diversification into new ETFs have only gained popularity somewhat recently. The original intent of the rule was to help facilitate the formation of new businesses, and Congress has taken steps in the past to tighten rules to prevent strategies such as this that allow for diversification without triggering taxes.
There’s also a lack of clarity around how the cost basis for new ETF shares should be tracked, which may impact how much savings investors realize from these exchanges.
More information here:
Is a 351 Exchange Right for You?
351 exchanges offer investors who have significant unrealized investment gains the opportunity to diversify their portfolio without triggering capital gains taxes. However, there are significant restrictions on the construction of your existing portfolio that may make it difficult to qualify for a 351 exchange. A lack of legal clarity surrounding the exchanges can also contribute to uncertainty around the potential savings.
If you have an investment portfolio with significant gains and want to look for ways to diversify, it’s worth consulting an investment advisor to see if a 351 is the right move. If you’re already pleased with your portfolio or don’t have significant unrealized capital gains, a 351 exchange is not worth considering.
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