How wealthy investors use ETFs to avoid capital gains taxes

After years of stock market growth, many investors are sitting on large profits in taxable accounts, which could trigger hefty capital gains when sold.  

That bill can be significant for wealthy Americans, with a 20% top capital gains rate, plus 3.8% net investment income tax, depending on earnings.  

One solution, known as a 351 conversion or exchange, allows higher earners to transform appreciated assets into shares of new exchange-traded funds. The strategy seeds ETFs before launch, and the original investor defers capital gains until selling their shares.

For some investors, the strategy is “like magic,” said certified financial planner David Haas, president of Cereus Financial Advisors in Franklin Lakes, New Jersey.  

One of the benefits of the ETF wrapper is that fund managers can accept assets before launch, and later rebalance without incurring gains.

While the volume of 351 exchanges for ETFs has increased in recent years, there are still relatively few public options, experts say.

Haas has used 351 conversions for certain clients. But there are some downsides to consider, he said. Here are the key things to know. 

Many higher earners keep some investments in separately managed accounts, or SMAs, which are taxable, customized portfolios with an active manager.

One benefit of SMAs is tax-loss harvesting, which uses losses to offset portfolio gains. But those opportunities “dwindle over time” as assets grow, said Daniel Sotiroff, a senior analyst for Morningstar Research Services.

Eventually, “there are fewer losses to harvest” and you can’t change investments without incurring capital gains, he said.

For some, 351 conversions to ETFs could solve the problem, he said.

Large financial planning firms that manage clients’ SMAs can create a private ETF via 351 conversions. More recently, smaller firms or SMAs can participate in publicly seeded ETFs. 

“I wouldn’t be surprised if we see more,” Sotiroff said.

However, minimum investments are still high. For example, Alpha Architect recommends a “minimum portfolio” of $1 million. Cambria Funds‘ first 351 ETF conversion launch in December 2024 also had a $1 million minimum for individuals.

While deferring capital gains taxes on embedded profits may be attractive, 351 conversions to ETFs have specific rules, experts say.

“You can’t just put one stock into a 351 exchange and get tax-deferred treatment,” Ben Henry-Moreland, a CFP with advisor platform Kitces.com, told CNBC.

There are strict diversification requirements to qualify for deferred capital gains. Your transferred assets are only “diversified” if:

• A single stock or company isn’t more than 25% of the contributed assets
• The five largest assets aren’t more than 50% of the contributed assets

Plus, certain assets, such as mutual funds or alternative assets such as private equity or cryptocurrency, may not be permitted for the transfer, Henry-Moreland wrote of 351 exchanges in March.

Before completing a 351 conversion, you should weigh the pros and cons and how it fits into your bigger financial plan. You’re swapping assets in exchange for the ETF shares, which may be different from your target allocation.

CFP Charles Sachs, chief investment officer of Imperio Wealth Advisors in Coral Gables, Florida, doesn’t use the strategy because he said it could leave clients with fewer options.

“You can do it, but you’re stuck in there,” Sachs said.

While it’s possible to transfer the funds via another 351 conversion, “there aren’t many companies doing this,” said Haas, of Cereus Financial Advisors. And if you sell, you could see capital gains.

“That’s super important to think about,” he said. “You have to be happy with the ETF.”