Recent strategies employed by wealthy investors reveal how 351 conversions to exchange-traded funds (ETFs) can serve as an effective tool for minimizing capital gains taxes. This approach enables the wealthiest Americans to reinvest their appreciated assets into entire new sectors of the ETF market. In part due to this recognition, large financial planning firms have adopted this process in droves.
Financial firms would be able to produce privately under the narrow rules for 351 conversions for ETFs. This allows clients to defer short- and long-term capital gains taxes on this asset growth. As David Haas of Cereus Financial Advisors recently noted, there are only a handful of companies doing 351 conversions at the moment. This points to a very specific, but quickly expanding, market segment.
Luckily, the mechanism of the 351 conversion makes this step quite advantageous. Additional flexibility Fund managers can take in-kind assets prior to the ETF’s launch and then rebalance the resulting portfolio without realizing any capital gains. This feature solves the problem of large capital gains tax liabilities sometimes associated with the sale of an asset. In return, it is always an attractive alternative for multiple investors. This strategy is not the magic bullet. Some assets, like mutual funds or other alternative investments, might not be eligible to transfer.
To receive tax-deferred treatment under a 351 conversion, certain requirements for diversification in ownership must be satisfied. Not one stock or company can represent more than 25% of the total contributed assets. Further, the five largest underlying assets combined cannot account for more than 50% of the weight. Ben Henry-Moreland emphasizes that “you can’t just put one stock into a 351 exchange and get tax-deferred treatment,” underscoring the importance of diversification in this approach.
Yet for all the compelling upsides, many financial advisors seem to be wary of the limitations that come along with 351 conversions. Charles Sachs expresses his reservations regarding the strategy, stating, “You can do it, but you’re stuck in there.” This statement shines a light on the rigidity that may set in after conversion. Investors may find it difficult to pivot when they commit down this route.
If approved, Cambria Funds would bring its first 351 ETF conversion to market in December of 2024. This may be a deterrent for individual investors, as they will need to make a minimum investment of $1 million. Ben Henry-Moreland suggests having a “minimum portfolio” of $1 million to get the most out of this strategy. This new approach is a blatant riposte for targeting high-net-worth individuals.
Over time, the number of 351 exchanges used by ETFs has dramatically increased. The number of public options to choose from is still very limited. It’s an opportunity that experts say becomes less and less viable the longer you wait. The more investors’ asset values rise, the more they limit future value-accruing tax-saving strategies.