A Good Problem to Have - But Still a Problem!

If you invested early in a stock like Apple, Lilly, or NVIDIA, you might not want to take the current tax hit from selling. Still, you also realize that your portfolio may have become overconcentrated in one or more stocks.

Bull markets are fun. It’s always nice to see your portfolio increasing in value. But what if you bought one or more of the big winners several years back and have held onto them? You could be looking at sizable, unrealized gains in your brokerage account.

To be sure, the problem of having too many gains in a handful of stocks is one many of us would love to have. That said, it is still a problem! If sentiment on one of your winners reverses, all those sweet, sweet, unrealized gains could disappear. Your tax problem goes away, but so does a chunk of your wealth. Not ideal! What to do? Enter the 351 exchange.

The 351 Exchange in a Nutshell

So, what exactly is a 351 exchange? Named for Section 351 of the US Tax Code, it is a mechanism by which an investor can swap existing holdings for shares in a newly launched ETF. The value held in the new ETF will match the value of the existing holdings at the time of transfer.

The investor’s holdings become part of the new ETF’s holdings. Your cost basis remains the same, but you have swapped a concentrated portfolio for a more diversified one. No taxes are owed at the time of the swap but would be owed if and when you sell shares of the ETF. In other words, it is a tax-deferral, not a tax-avoidance strategy.

Two Hurdles

Investors face two primary hurdles in qualifying for a 351 exchange. The first is portfolio minimums. ETF managers typically require a minimum contribution of $1,000,000 for individual investors, though some can be even higher.

Secondly, there are diversification requirements. You are not allowed to contribute a single stock in a 351 exchange. Rather, contributed portfolios must meet the so-called 25/50 test. No single security can exceed 25% of the portfolio you are contributing.

Furthermore, the top five securities in the contributed portfolio cannot exceed 50% of the portfolio’s value. Notably, cash is excluded from those calculations, so you could not contribute a portfolio consisting of $750,000 in cash and $250,000 of NVDA.

There are also some limits on the types of assets which can be contributed. Most notably, mutual funds are not eligible. Other excluded assets include crypto, closed-end funds, and private investments.

One Potentially Big Caveat

As these exchanges have grown in popularity, they have caught the attention of regulators. Both the US Treasury Department and the IRS are taking a closer look at 351 exchanges to ensure that they are legitimate and do not constitute an abuse of the tax code.

At this time, we have no idea what, if any, impact this will have on the practice. But investors should at least go in knowing that potential changes are on the horizon.

Summary

351 exchanges offer investors the opportunity to reduce concentration without incurring taxes. However, the hurdles noted above mean that they are appropriate for only a small subset of investors.

If you do qualify and are interested in a 351 exchange, keep an eye out for announcements from the Treasury Department and/or IRS to make sure that these strategies remain viable.

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