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351 ETF Conversions

by Jul 28, 2026All, Investments, Taxes

For investors sitting on a concentrated position with large unrealized gains, Section 351 exchanges have become one of the more useful planning tools. Rather than selling appreciated stock and triggering the capital gains tax, an investor contributes those shares to a newly formed ETF in exchange for fund shares. If the exchange meets the Section 351 requirements, it’s tax-deferred, and the existing cost basis and holding period carry over. Until recently, most of these options were higher-fee actively managed funds, but low-cost index-tracking versions (with expense ratios under 0.10%) are now becoming available, broadening who this makes sense for.

After the exchange, the investor receives a diversified portfolio in the form of an ETF, with no taxable gains. Going forward, the ETF’s in-kind creation and redemption mechanics defer capital gains distributions, which typically allow the ETF to avoid realizing capital gains at the fund level.

351 Exchange Requirements

Two main tests have to be met:

  1. Each contributed portfolio must be diversified: no single holding above 25%, and the top five combined no more than 50%.
  2. The contributing investors as a group must own at least 80% of the new ETF immediately after the exchange. Individual stocks and other ETFs are the most straightforward assets to contribute; mutual funds, REITs, and certain other holdings raise complications that can make funds unlikely to accept them.

A key nuance is the ETF look-through rule. When the contributed portfolio includes shares of an ETF, the IRS treats the ETF as its underlying holdings rather than a single position. Contributing an S&P 500 ETF, for example, means each of the 500 underlying stocks counts separately for the test above, which can make the diversification test far easier to satisfy, and often a portfolio anchored by a broad ETF passes on its own.

Examples of Passing and Failing 351 Exchange Contributions

✓ Passes: 11 stocks, equal-weighted

Each position ~9.1%; top five combined ~45.5%. Ten equal-weight positions is the theoretical floor (top five = 50% exactly), so eleven gives a small cushion.

✗ Fails: 9 stocks, equal-weighted

Each position is only ~11.1% (well under the 25% cap), but the top five combined comes in at 55.6%, over the 50% ceiling. A common miss when the portfolio looks diversified on the surface.

✓ Passes: Single broad-market ETF (e.g., VTI or an S&P 500 fund)

Look-through means the underlying 500+ stocks count individually. Diversification is easily met.

✓ Passes: 18% NVDA + 82% S&P 500 ETF

NVDA already makes up about 7% of the S&P 500 (as of July 2026). After look-through, total NVDA exposure works out to roughly 23.7%, just under the 25% cap. Top five combined comes in around 40%.

✗ Fails: 20% NVDA + 80% S&P 500 ETF

Only two percentage points more direct NVDA, but after look-through the total climbs to about 25.6%, just over the 25% cap. The tipping point sits around 19% direct NVDA, so the margin here is razor-thin.

✓ Passes: 25% in one stock + 15 others at 5% each

The concentrated position sits right at the 25% cap, and the top five combined comes in at 45%. Spreading the balance across enough other names keeps the top-five test under 50%.

✗ Fails: 25% in one stock + 10 others at 7.5% each

The 25% position is right at the cap, but the top five combined comes in at 55%, over the 50% ceiling. Same concentrated position as above; the difference is how thinly the rest of the portfolio is spread.

When 351 Exchanges Make Sense

The strategy is most useful for investors with a taxable account carrying meaningful embedded gains, especially those with a concentrated position they’d like to diversify away from. A few things to keep in mind: basis is carried over, not stepped up, so the tax is deferred rather than eliminated. And the process is a one-time event tied to the launch of a specific ETF, so timing and product selection matter.

One important limit: because no single holding can exceed 25%, an investor needs to bring at least 3× the concentrated position in other assets for it to fit under the cap. That means the strategy can’t fully diversify away a truly overwhelming single-stock exposure. In those cases Section 351 may still help meaningfully, but it won’t be a complete solution on its own.

For the right situation, the after-tax benefit can be substantial. If you have a concentrated position you’ve been reluctant to unwind because of the tax bill, this is a strategy worth discussing.

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Astra Wealth Partners LLC is a registered investment adviser registered with the United States Securities and Exchange Commission.

Registration does not imply a certain level of skill or training. The views and opinions expressed are as of the date of publication and are subject to change. The content of this publication is for informational or educational purposes only. This content is not intended as individualized investment advice, or as tax, accounting, or legal advice. Although we gather information from sources that we deem to be reliable, we cannot guarantee the accuracy, timeliness, or completeness of any information prepared by any unaffiliated third-party. When specific investments or types of investments are mentioned,  such mention is not intended to be a recommendation or endorsement to buy or sell the specific investment.

The author of this publication may hold positions in investments or types of investments mentioned. This information should not be relied upon as the sole factor in an investment-making decision. Readers are encouraged to consult with professional financial,  accounting, tax, or legal advisers to address their specific needs and circumstances.

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