A Smarter Way to Diversify: Tax Benefits of 351 Conversions

08/12/2025

Most investors can agree on one thing: paying capital gains taxes can be painful. If you are investing in a taxable account, Uncle Sam becomes a silent partner – ready to take his cut whenever you cash in on your gains.

Over time, compounding can lead to significant growth in individual stocks, especially when held for many years. That growth, however, often creates a problem: the tax burden from selling highly appreciated stocks can make it hard to manage and diversify the investment portfolio. The result? Portfolios that become overly concentrated in a single stock or sector—introducing more risk than many investors intended.

Think of an Apple position purchased 15 years ago – a position with strong performance and likely with a significant large unrealized capital gain. If you are looking to diversify, what are your options?

A little-known provision of the tax code—Section 351—can offer a solution. Section 351 of the Internal Revenue Code has been around since the 1950s. Historically, Section 351 was mainly used to let people transfer valuable real estate to a corporation without having to pay taxes right away. These days, it’s also being used to defer taxes on financial assets.

A Section 351conversion allows investors to contribute appreciated securities (such as individual stocks) into a newly launched exchange-traded fund (ETF), without triggering capital gains taxes at the time of transfer.

A Section 351 ETF conversion offers eligible investors a way to move concentrated positions with large unrealized gains into a more diversified portfolio—without triggering immediate capital gains taxes. Once the legacy holdings are inside the ETF, they can be repositioned more flexibly, and taxes are only due if and when the investor sells the ETF shares. This strategy not only defers taxes but also provides ongoing tax efficiency, as ETF managers can adjust the fund’s holdings without passing along taxable gains. Investors also gain more control over when they realize taxes, helping them manage their overall tax picture more efficiently.

Who may benefit?

• Retirees seeking to better control the timing of their capital gains which not only have an impact on their overall tax bill but may also affect their Medicare premiums or other tax credits and deductions.
• High-net-worth families seeking to minimize concentration risk while preserving step-up in basis for estate planning.
• Younger investors are building taxable portfolios who want to maximize long-term, tax-deferred growth.

While this may seem “too good to be true,” it’s important to note some limitations and requirements:

• Investors must contribute a “diversified” portfolio to participate in a 351 Conversion.  No individual security can be more than 25% of the total assets contributed to the ETF.  Additionally, the market value of the top five holdings must be under 50% of total assets contributed.
• This strategy is only available at the launch of a newly formed ETF. Once the fund is trading publicly, investors would need to sell appreciated positions and realize gains before reinvesting—eliminating the key tax advantage.
• Prospective investors must meet various requirements to be eligible for tax deferment under Section 351. Certain assets such as mutual funds and alternative investments may not be eligible for a Section 351 exchange.

By understanding and leveraging the power of Section 351 conversions, eligible investors can take a proactive step toward smarter diversification—unlocking long-term growth potential while keeping more of their gains working for them, not Uncle Sam.

Want to learn more?
Since 1933, NPF Investment Advisors has guided clients through tax-efficient investment strategies. We’d be glad to explore how this approach might support your long-term goals. Contact us at npf@npfinvest.com to learn more.

ETFs are securities products that are distributed through registered broker-dealers. The information discussed herein is for informational purposes only and is not intended as investment advice or a recommendation to buy or sell any security, including ETFs. Investing in securities carries an inherent element of risk. Before investing in securities – including ETFs – investors should carefully consider the investment objectives, risks, charges, and expenses relative to their financial situation.