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In an effort to simplify and consolidate my portfolio, I recently completed what’s known as a Section 351 exchange in a taxable account. This provision of the Internal Revenue Code lets investors transfer assets—such as stocks and securities—to a corporation without recognizing a taxable gain or loss, provided certain conditions are met.
With help from my financial consultant, I exchanged a portfolio of individual stocks in a separately managed account (SMA), held since 2020, for shares in a new exchange-traded fund (ETF). Because the transaction qualified under Section 351, it was tax-free, and my original cost basis carried over to the ETF.
The SMA portfolio held global growth equities, with both long- and short-term gains and losses. The new ETF—a focused growth fund—owns many of the same companies. In fact, the SMA’s asset manager launched this ETF, offering SMA clients the opportunity to contribute their holdings during its initial seeding via the 351 exchange. I could have included other stocks or ETFs I held elsewhere, but I limited the exchange to the SMA positions.
Since opening the SMA, I’ve tracked every purchase, sale, and dividend in Quicken (dividends were not reinvested). I also managed tax-loss harvesting, instructing the manager to temporarily replace any sold stock with an index fund for 30 days to avoid the wash-sale rule. Keeping the SMA synchronized in Quicken took time and discipline, but it provided useful insight into performance and taxes.
There’s an after-tax advantage to ETFs compared with SMAs. I was provided the following example: assuming an 8% annual return, 20% turnover, and less than 1% in dividends, the ETF structure can deliver roughly a 1-percentage-point annual savings after accounting for fees and taxes. Before the exchange, I harvested stock lots with losses to offset this year’s SMA capital gains.
The exchange itself was efficient—only three business days from the removal of the SMA stocks to receipt of the ETF shares. The brokerage provided detailed tax-lot information, including share counts, cost basis, and unrealized gains and losses. Although Quicken doesn’t have a one-click “351 exchange” transaction, it can be recorded accurately by treating it as a non-taxable security swap, ensuring the cost basis carries over properly. (I followed a process laid out by ChatGPT.)
Investors aren’t locked into the ETF. Once received, ETF shares can be sold, donated, or even used in another 351 exchange. Several new ETFs are now being launched through this mechanism, accepting stocks and other securities from investors across multiple custodians. These funds can offer an efficient way to diversify or rebalance portfolios—say, shifting from concentrated technology holdings to value, international, or fixed-income assets—all while deferring taxes.
Hey Ed, would you be interested in writing an article about this topic in-depth (fees, process, etc). I think many people would find this beneficial (me included)
Bogdan, thank you for your interest. I am not an expert on the process. I worked with my financial consultant, who works for a wealth management firm and alerted me of this opportunity. From what I gathered many of the firm’s clients participated in this exchange. They provided me a Primer on the 351 exchange, described the process, answered my questions and handled all the paperwork. Bottom line is you need to become aware of an investment management company that is establishing a new ETF using a 351 exchange where you can participate in seeding the ETF with securities. Polen, Cambria, Alpha Architect and Longview are a few companies that have launched ETFs using a 351 exchange and more will follow. The process was straight forward for me since the same company that managed my separate managed account (SMA) started the ETF and handled the transactions. Shares were removed from the SMA and exchange for shares in the ETF without triggering a taxable event. Capital gains carried over. I tracked the process and recordkeeping online through my brokerage (custodian) account and loaded the pertinent data into Quicken. There were no additional costs to me. The ETF expense fee is actually 0.01% less than the SMA fee.
Interesting.
To make sure I understand the capital gains benefit… I gather the idea is that once in the ETF, my old holdings are partially (or completely) swapped into far more, and since that is taking place inside the ETF wrapper, the gains are to the ETF, which because of its unique structure usually doesn’t have to make distributions. So I get the higher diversification without the gains I’d realize by making the trades in my own account.
Still, the old cost basis is carried forward, and if I ever want some money, I will incur the gains. Further, when that time comes, I won’t be able to pick and choose what to sell; that potential tax management tool is gone forever.
Re Jeff Long’s comment, I’d also want to be sure my cost basis in the ETF would be fully stepped up for my heirs.
I see the benefit if one has an overly large holding that they want to diversify out of. But to consolidate an already diversified portfolio of tens of individual stocks into one ETF just for simplicity, I’m not sure there’s much attraction.
Michael, thank you for your comment. On whether the cost basis in the ETF would be stepped up to heirs, the answer is yes as long as the ETF is included in the decedent’s estate. The basis is stepped up (or down) to the fair market value at the date of death (§1014 of the Internal Revenue Code). I completed 3 tax loss harvesting events while owning the SMA. I didn’t wait until the end of the year, but instead did them when there was a reasonable loss to be worth the effort, e.g., record keeping, completing tax forms, etc. Each time, on average, the value of stocks sold advanced slightly more during the 30-day period than at the time of sale. So did the index fund I bought in their place (which provided a realized short-term capital gain). So, I’d call it about even, while harvesting the losses. So that worked out well. The timing was a gut call. Yes, I will lose that capability, but when factoring the size of this investment to my overall portfolio, it only had a marginal impact. That’s one reason I opted for simplicity and consolidation. In the future I hope to exchange this focused growth ETF to a more broad-based fund.
Thanks Ed. It appears you could make that move via a 351 exchange also, according to Alpha Architect’s intro to the topic, which your piece led me to read, link below for others.
I suppose my next question to myself would be whether I want the new ETF to begin with. It’s going to be actively managed, and there’s no Morningstar or other independent analysis of its management or performance, so not something I’d buy normally.
Btw don’t discount writing an article about this because you’re not an expert. I’ve written a couple of articles on things I wasn’t expert on either. It has had the benefit of inviting others who were experts educate me in their comments.
🙂
https://alphaarchitect.com/wp-content/uploads/compliance/etfarchitect/Intro%20to%20ETF%20Taxation%20and%20351%20Conversions.pdf
This is what I like about Humble Dollar, being able to interact with other readers, whose opinions I very much appreciate & value. Your points are valid. As far as an actively managed ETF, there are narrow benchmarks to compare performance to. I’m familiar with the management of the ETF, since they managed my SMA. It would be prudent to research the management team of any new fund and gain a level of conviction before investing in it. I think my next article will be on Bitcoin. I have a new perspective after reading “The little Book of Bitcoin” by Anthony Scaramucci.
Another tool in the toolbox. Thanks for sharing.
Never used 351 for other than incorporating a small business. Concerned on death of the shareholder(s) basis step up would be to the corporate shares, based on the FMV of the contributed shares, but the basis of the contributed shares would not change.
This is very interesting; I never heard of it. Thanks for describing the process.