Many investors face a difficult tradeoff at some point in their investing career. They have some stock that they want to sell, but it is at a large gain. They want to diversify or rebalance their portfolio but don’t want to pay the taxes associated with selling the position. Many of our clients face this dilemma either from stock positions they have accumulated from their employer over a career or old investment decisions that have lingered in individual stocks.
Unfortunately, there haven’t been good options to solve this issue. Historically, investors have tried using things like options or exchange funds, but these solutions are costly, tax-inefficient, and illiquid.
As wealth managers, we always look for that third door that can efficiently solve a client’s need. 351 conversions beautifully solve this issue. They are low-cost, have zero tax impact, and are liquid.
What is a 351 Conversion?
A 351 conversion or exchange refers to a section of the Internal Revenue Code that deals with corporate reorganizations. This code section allows for a tax-free exchange of securities into a newly created entity, such as an ETF, provided certain diversification rules are met. In other words, the Code allows individuals to exchange holdings of stocks or ETFs into a new ETF in a tax-free conversion with a carryover basis.
Why does this matter to me?
Any investor can seed (put money in at launch) an ETF with individual stock positions and immediately convert their investments from whatever they held to a fully diversified ETF tax-free. Your original cost basis carries over, but now, instead of holding a handful of individual stocks, you can hold a low-cost, diversified, transparent ETF that can rebalance itself and pursue higher returns without incurring capital gains.
What are the limitations?
“There must be a catch! This seems too good to be true. How do I get to go from concentrated stock positions to a diversified investment portfolio without paying taxes?” Yes, 351 conversions are highly effective tools for investors; however, there are several limitations as to when and how they are implemented.
First, the investments that an investor converts must be “diversified,” which means that investors cannot seed a new ETF solely with a single stock (e.g., Apple, Boeing, or Tesla). Specifically, the largest single position cannot exceed 25% of the contributed portfolio, and the five largest positions cannot exceed 50% of the contributed portfolio. While this may limit how much of an existing portfolio an investor can convert, an investor can combine individual stocks and additional ETFs to meet this criteria. Second, 351 conversions can only be done when an ETF first launches…not whenever an investor wants to.
Summary
A 351 conversion is a unique opportunity for investors to improve and diversify their investment portfolio without incurring current capital gains taxes. It allows investors to convert unwanted positions with significant capital gains into a diversified, tax-efficient, low-cost ETF in a non-taxable event.
Why should I care about 351 conversions? We want our clients and the investing community at large to benefit from a 351 conversion in the future, should it become available. Please stay tuned for more details as we prepare to do our own 351 conversion in the coming months!
If you have or know someone who has a low-basis stock portfolio or ETF that may benefit from better diversification but has hesitated to do so out of fear of incurring severe tax consequences, please reach out. A 351 conversion might be the right solution.
This information is educational and does not intend to make an offer for the sale of any specific securities, investments, or strategies. Investments involve risk, and past performance is not indicative of future performance. Return will be reduced by advisory fees and any other expenses incurred in the management of a client’s account. Consult with a qualified financial adviser or tax professional before implementing any investment or tax strategy.
