New Strategy to Sell Stocks—Without Actually Selling or Paying Taxes
Use of retirement plans, 1031 and 1035 tax-free exchanges are all well-known strategies to avoid or defer capital gains when selling assets. However, our focus is on a newer strategy that focuses on marketable stocks and Exchange Traded Funds (ETFs).
Many investors face a common challenge—overexposure to a single stock such as Apple or another very large position. Other investors may be holding older, underperforming assets like 3M or Zimmer Biomet, but with large past imbedded capital gains. Selling to rebalance would trigger large capital-gain taxes, yet holding the same positions indefinitely concentrates risk or could result in long-term underperformance.
A Section 351 ETF exchange offers a solution. It allows investors to transfer appreciated stocks and stock ETFs tax-free into a newly created ETF—achieving diversification, maintaining market exposure, and deferring taxes on unrealized capital gains.
How a Section 351 Exchange Works
Under IRC Section 351, investors can contribute appreciated securities directly into a new ETF at launch. If the contribution meets IRS diversification standards, no capital gains are recognized, and the ETF shares carry over the original date of purchase, lot, and cost basis of the contributed securities.
To qualify, the 25/50 diversification test under §368(a)(2)(F) must be satisfied:
• No single stock can represent more than 25% of the contribution’s total value.
• The top five holdings combined cannot exceed 50% of the contribution’s value.
• Look-through treatment of ETFs: When an ETF is contributed, the IRS views it as owning each underlying stock within the fund rather than as a single security. This allows diversified contributed ETFs like SPY, RSP and others to satisfy the test.
Certain ETF creation rules were clarified in 2019, giving additional needed guidance before ETFs could be created that were IRC 351 compliant. It took ETF sponsors several more years to set up procedures before they began offering them, which is why 351 ETFs are new to the tax-deferral scene.
In practice, structuring a 351 exchange generally means adding just over $3 of other qualifying securities for every $1 of a single-stock position in order to stay within the 25% threshold and qualify for tax-deferred treatment.
Example
Contributions of three stocks and two ETFs into a new 351 ETF
| Holding | Market Value ($) | Cost Basis ($) | Unrealized Gain ($) | % of Total Contribution | Comment |
| Apple (AAPL) | 250,000 | 60,000 | 190,000 | 22.7% | Overconcentrated position |
| 3M (MMM) | 100,000 | 60,000 | 40,000 | 9.1% | Legacy industrial |
| Zimmer Biomet (ZBH) | 100,000 | 70,000 | 30,000 | 9.1% | Legacy healthcare |
| SPDR S&P 500 ETF (SPY) | 100,000 | 75,000 | 25,000 | 9.1% | Diversified S&P ETF |
| S&P 500 Equal Weight ETF (RSP)* | 550,000 | 550,000 | — | 50.0%, but less than 1% to any one stock | Broad equal-weighted ETF added for diversification |
| Total to 351 ETF | 1,100,000 | 815,000 | 285,000 | ≈ $285,000 Deferred Gain |
*RSP is purchased just prior to the 351 exchange to supply sufficient assets in order to divest more Apple stock and still meet the IRS tax deferral 25% rule requirement. Without RSP, only half of the Apple shares shown above could be divested via a 351 ETF.
Result: Approximately $285,000 in unrealized gains are deferred and for a high tax bracket investor roughly $68,000 in projected taxes is avoided. Apple position and legacy positions are reduced in favor of a new diversified U.S. stock ETF.
After ETF Formation — Creating Liquidity Without Taxes
Because RSP was purchased just prior to the 351 ETF exchange in this example, it has a high-cost basis and represents half of the contributed value. Once the ETF launches (typically about 30–45 days later), the investor can sell those high-basis shares with no taxable gain, assuming no price change during this short period. The remaining ≈ $550,000 of low-basis 351 ETF shares continue to defer ≈ $285,000 of embedded gains inside the diversified ETF structure. Post 351 ETF trading liquidity is often low, so certain trading techniques may be required to avoid poor pricing when selling.
Step-by-Step Timeline
| Step | Typical Timeframe | Description |
| 1 – Portfolio Review | Weeks 1–2 | Verify 25/50 diversification compliance and select holdings for the exchange. |
| 2 – Documentation and Custody Process | Weeks 3–4 | Prepare transfer agreements and coordinate with the ETF sponsor to execute the in-kind exchange. |
| 3 – ETF Formation and Launch | Weeks 5–6 | Contribute assets in kind to the newly formed ETF and receive new ETF shares of equal value. |
| 4 – Post-Launch Window | Weeks 7–8 | Sell high-basis ETF shares with minimal taxes while retaining low-basis shares for long-term tax deferral. |
If using an investment advisor, most of the steps shown above take place between the investment advisor and the 351 ETF sponsor. Popular 351 ETF sponsors include Cambria, Toews, Astoria, and others. A recent one is an ETF with a mandate to own the largest 500 U.S. stocks, equally-weighted. Each 351 ETF has its own diversified stock strategy that needs to be evaluated prior to purchase. The ETF management fee should be evaluated too.
Once the new 351 ETF is trading, no more tax-free asset exchanges into it can be made. It trades like any other ETF at this stage. All tax-free contributions must be completed before the ETF begins trading. This is why new 351 ETFs are being created throughout the year by different sponsors. Tracking pending 351 ETFs is a requirement to employ this strategy.
WESCAP Group provides portfolio management and planning strategies designed to help clients optimize after-tax outcomes. This content is for informational purposes only and not to be construed as individualized tax advice. For more details, please contact us.