After years of strong stock market performance, many investors now find themselves holding substantial unrealized gains in their taxable portfolios. When these appreciated assets are sold, they can trigger steep capital gains taxes — a reality that has many high-net-worth individuals looking for smart ways to defer or minimize their tax burden.

For wealthy Americans, this tax hit can be significant. The top federal capital gains rate sits at 20%, and those with higher earnings may face an additional 3.8% net investment income tax. To manage this, some investors are turning to a lesser-known but increasingly popular tax strategy known as a 351 exchange or 351 conversion. This approach allows them to exchange appreciated assets for shares in new exchange-traded funds (ETFs), delaying the realization of gains until the ETF shares are eventually sold.

Certified financial planner David Haas, president of Cereus Financial Advisors in Franklin Lakes, New Jersey, described the appeal of this approach, noting that for many clients, the tax efficiency can feel “almost magical.”

One of the reasons ETFs work so well in this context is that fund managers can accept assets before an ETF officially launches. Afterward, they can rebalance the portfolio internally without realizing taxable gains, making ETFs an efficient vehicle for investors seeking to manage large, appreciated holdings.

Although the use of 351 exchanges for ETFs has grown in recent years, experts say this market segment remains relatively niche, with limited publicly available options. Haas, who has implemented this strategy for certain clients, cautions that investors should fully understand its mechanics and limitations before proceeding.

How 351 Conversions to ETFs Operate

Many affluent investors hold assets in separately managed accounts (SMAs) — personalized portfolios managed for a single investor that are often taxable. A key advantage of SMAs is their ability to employ tax-loss harvesting, offsetting realized gains by strategically selling losing positions. However, as portfolios grow and accumulate gains, opportunities to harvest losses naturally decrease.

“Eventually, you reach a point where there are fewer losses left to offset,” explained Daniel Sotiroff, a senior analyst at Morningstar Research Services. “You can’t make significant portfolio adjustments without triggering capital gains.”

For investors in this position, a 351 conversion into an ETF can offer a potential solution. Large financial advisory firms managing multiple SMAs can use this strategy to form private ETFs, while smaller firms can join publicly seeded ETFs that allow participation from multiple investors.

“I wouldn’t be surprised to see this trend expand,” Sotiroff added, noting that as awareness grows, more firms may explore this structure.

However, minimum investment thresholds remain high. For example, Alpha Architect — one of the early leaders in this area — recommends a minimum portfolio size of $1 million. Similarly, Cambria Funds’ first 351 ETF conversion, launched in December 2024, required a $1 million minimum for individual investors.

Diversification Rules Are Crucial

While the opportunity to defer capital gains is appealing, 351 conversions come with strict IRS diversification requirements that investors must meet to qualify for tax deferral.

“You can’t just place one stock into a 351 exchange and expect tax-deferred treatment,” explained Ben Henry-Moreland, a certified financial planner with Kitces.com.

To qualify, the contributed portfolio must meet certain diversification standards:

• No single stock or company can make up more than 25% of the total assets transferred.
• The five largest holdings combined cannot represent more than 50% of the total assets.

Additionally, some types of assets — such as mutual funds, private equity, or cryptocurrency — typically cannot be included in a 351 exchange, as noted in Henry-Moreland’s March analysis on the topic.

Weighing the Risks Before You Commit

Despite the advantages, financial planners warn that 351 conversions are not a perfect fit for everyone. The strategy can limit flexibility once the conversion is complete.

“When you execute a 351 exchange, you’re swapping your current assets for ETF shares,” said Charles Sachs, chief investment officer at Imperio Wealth Advisors in Coral Gables, Florida. “If those ETF holdings don’t align with your overall investment goals, you might find yourself stuck.”

While it’s technically possible to transfer ETF holdings again through another 351 conversion, such opportunities are rare. “There aren’t many firms actively offering these transactions,” noted Haas of Cereus Financial Advisors. And if an investor decides to sell their ETF shares instead, the deferred gains become taxable at that point.

“That’s a crucial detail investors often overlook,” Haas emphasized. “Once you’re in, you need to be comfortable holding that ETF long-term.”

In short, 351 conversions can provide a powerful tool for deferring taxes and improving portfolio efficiency, particularly for investors facing large unrealized gains. However, as with most sophisticated financial strategies, success depends on careful planning, diversification, and a clear understanding of the trade-offs involved.