Educational Spotlight: Section 351 Exchanges
Educational Spotlight Section 351 Exchanges
For generations, real estate investors have relied on IRS Section 1031 to do “exchanges” of their investment real estate without causing tax realization. This feature has been one of the pillars that have made real estate investing with taxable (non-retirement) money attractive. Investors can adjust their portfolio to reflect their current needs and the present opportunities while still deferring taxes. What if equity investors could do the same? Now, they can.
To set up this article, let’s look at the background of equity investing and taxation. US income taxation is based on “realized” income, meaning there has been a transaction, such as interest or dividends paid or a sale. Investors who sell one stock to buy another owe taxes on any gains realized. The sell is the taxable transaction. Buy-and-hold investors can defer taxes for a very long time. Mutual funds are pass-through vehicles, which distribute capital gains to their investors, who are then responsible for the taxes on the gains based on the fund’s holding period, not their own. When a Mutual Fund sells shares for a gain, it’s current investors realize taxable income. Exchange Traded Funds (ETFs) are more tax efficient, because they are able to buy and sell without generating taxable events for their investors who are only taxed when they sell the fund – same as a stock. Targeting a long holding period of individual stocks and ETFs is a good tax deferral strategy, but what happens when divergent returns cause one investment to become a disproportionate part of the portfolio? Investors with highly appreciated investments in taxable accounts are in a quandary. They purchased those securities at much lower prices, and may not buy them today at current prices. Further, the portfolio allocation has drifted as certain stocks or sectors appreciated far more than others. The portfolio is now concentrated in stocks whose valuation may be stretched. If the investor trims these positions and rebalances the portfolio – a historically sound strategy – there will be significant taxes due. A Section 351 exchange can solve this problem.
What is it?
Section 351 has been around for a long time, and was set up to allow investors to contribute in-kind for business equity. If a person wants to contribute equipment needed by a company for ownership in the company, rather than selling the equipment to the company and generating a taxable gain and then buying equity in the company, the equipment owner can swap the equipment for equity, and the equity has a tax cost basis carried over from whatever the cost basis of the equipment was. This tax code section works for stocks going into an Exchange Traded Fund as well. Investors can trade their shares in individual stocks for shares in newly formed ETF and carryover their basis without realizing gains, as long as the ETF manager is willing to accept the shares instead of cash. Mutual Funds have used this Section to convert mutual fund shares to ETF shares. Now, a few ETF sponsors are launching new funds to facilitate the contribution of shares into the ETF.
How does it work?
Just like a 1031 exchange for real estate has rules which must be followed precisely, so does a 351 exchange. First, the securities must be contributed to a newly formed ETF. This means an investor wishing to do a 351 exchange must find a newly launching ETF willing to participate in the exchange. Second, there are concentration limits on what can be contributed. No one security can be more than 25% of what is contributed, and the top ten must be less than 50%. Contributed ETFs are treated on a look-through basis. For instance, if an investor contributes SPY, which has an 8% weight in NVDA, 8% of the SPY contribution would count as NVDA, etc. Finally, contributed securities need to be accepted by the ETF the investor is exchanging into. If it is an equity fund, it may not accept fixed income or international equity ETFs.
What are some use cases?
While the 351 exchange won’t help an investor with a portfolio of five highly appreciated stocks and nothing else, it can be a great tool to reduce concentration in a handful of highly appreciated positions.
Consider a hypothetical investor with fifty individual stocks, with the five biggest positions comprising 50% of the portfolio. The investor will not be able to exchange the whole portfolio (the numbers 6-10 positions would have to have a cumulative weight of zero), but can strategically contribute a large portion of those five biggest positions, along with the other positions to exchange into a more diversified fund. If the next five biggest positions totaled 20%, for a total concentration of 70% in the biggest ten securities, the investor would have to keep about a third of investment in the top ten securities, and could swap the rest.
An investor with a mix of some individual stocks and some ETFs has more flexibility. This can be a bit of a puzzle if the ETFs have large positions in the same securities, but if there are different ETFs that aren’t completely overlapping, the contribution can be optimized to come close to the limits without exceeding them.
An investor with funds that have concentrated positions, such as a technology fund, growth stock fund or even the Nasdaq, can swap those funds for a 351 eligible fund with a very different mix, getting instant diversification. For instance, the Vanguard Information Technology Fund (VGT) has a 43.6% concentration in its top three positions, but only 14% in the next seven. On its own, it is too concentrated, with about 58% in the top ten stocks. The Vanguard Growth Fund (VUG) has 33% concentration in the same top three, and 60% in its top ten, so it would also not qualify. The two funds have 51% overlap, with almost all of that overlap being in the top five stocks. An investor could contribute a mix of these two funds with a small amount of other stocks or funds with low overlap to come just inside of the thresholds and achieve a significant improvement in portfolio diversification. At the time of this writing, SPY – an S&P 500 Index fund – has 39.4% of its value in ten stocks (nine companies), most of which are highly correlated with each other. While this is considered a diversified portfolio, it’s returns over the recent years are mostly driven by what happens with this small subset of stocks. If one exchanged from SPY or another S&P 500 index fund into an equal weighted ETF targeting the 500 largest companies, the weight of these biggest nine companies would drop from 39.4% to 2%.
Any cash contributed to a 351 exchange does not count toward the diversification requirements, but an investor could take cash to buy a non-overlapping fund, such as a midcap fund to help meet the diversification requirements.
A Section 351 exchange can provide instant diversification, but is limited to what the replacement fund holds – if it is also concentrated, then the diversification goal may not be fully met. The tax cost-basis carries over, so an investor will probably want to hold or only slowly divest the new fund, which means it is really important what the composition, strategy and fee structure of the new fund is.
Conclusion: A Section 351 Exchange is a good tool to help investors diversify from a basket of highly appreciated stocks or from sector or strategy ETFs that have had a strong run and now present concentration and valuation risks to the portfolio. They can’t diversify a single stock position or an extremely concentrated portfolio – for that the investor could use an Exchange Fund, or a Charitable Remainder Trust, or a Qualified Opportunity Zone if a move into real estate is acceptable. For many investors, though, Section 351 presents a great opportunity to move away from the narrow sliver of stocks that have driven most of the stock market return over the last several years and now trade at nosebleed valuations. Implementation can be tricky, and choosing the right replacement fund is essential, so working with a good financial advisor who understands the rules and the process is prudent.
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