How to Diversify a Concentrated Stock Position Without Selling: Section 351 Explained
Has one or several stocks taken over your portfolio? With the rise of the “Mag 7” and AI related stocks as of late, Portfolios have found themselves very concentrated in just a few positions. We at Innova aim to highlight the advantages of diversification, however selling these appreciated positions can have major tax implications and leave investors hesitant to rebalance their portfolio even when they realize the inherent risk involved. We never want to “let the inmates run the asylum” in a portfolio but it can be difficult to swallow the tax implications of selling highly appreciated stock positions, especially if only held for a short period. So, what can an investor do?
Introducing 351 Exchanges!
First, what are they? A 351 exchange is a tax deferred transaction under Section 351 of the U.S. Internal Revenue Code that allows investors to transfer appreciated securities into a newly formed corporation or Exchange Traded Fund (ETF) without paying immediate capital gains tax.
What does this mean for investors:
Subject to certain limitations (limitations reviewed in “Some important considerations” section), you can hand over a basket of highly appreciated stocks or assets to “seed” the launch of a brand-new ETF. Other investors do the same so that the new ETF is seeded by many individuals all contributing their own highly appreciated positions. In turn for handing over your highly appreciated positions, you receive shares of the new ETF.
Why does this matter?
It matters because once the ETF managers receive all the assets, they can use a strategic tax maneuver called in-kind creations and redemptions to push out all the highly appreciated positions and reinvest into a diversified portfolio without creating any taxable transactions. If done correctly, you hand over your concentrated positions and receive a diversified portfolio without creating a taxable event! Or said differently you’re able to diversify without selling or paying any taxes!
Some important considerations:
It’s important to remember that your embedded gains don’t disappear, the basis of your individual positions carries over into your new ETF holding. So, for instance, if you had $1,000,000 in short term gains in the positions you handed over, you’d also have $1,000,000 in short term gains in your new ETF holding, however holdings would move from a few concentrated positions into a broadly diversified portfolio. The embedded gains don’t go away; they’re just transformed into a diversified portfolio. Another important consideration is that there are diversification limits that must be met regarding the assets you’re contributing to the fund. The rules are as follows, no one position can make up more than 25% of the portfolio you’re contributing and the top five positions you’re contributing cannot exceed 50% of the portfolio. An important caveat is that ETFs are considered “look through” assets so that when assessing the diversification rule it’s not the amount in one ETF but when looking at what the ETF holds in its underlying portfolio.
For example, if you contributed a portfolio that consists of 9% NVIDIA and 91% SPY (an S&P 500 index ETF) you would pass the diversification test because when looking through SPY no one individual holding would be more than 25% and the top 10 holdings would make up less than 50%.
Another consideration is that you’ll want to own the ETF you’re exchanging your shares for. The ETFs are usually structured to perform like broad market indexes but can sometimes be more customized to include international exposure or equal weight instead of market cap weighted indexes which all have different return and risk characteristics. In addition, the ETFs will come with, albeit low, expense ratios which will come out of the fund’s performance if you hold the position.
Finally, the timing of these transactions matter as well. You cannot use a 351 exchange to contribute assets to an ETF that already exists. As mentioned above your assets must be part of the “seed” process of a new ETF for the 351 exchange to work, so you must locate an issuer that has an upcoming launch, get comfortable with them and the ETF they are proposing, and indicate interest before the deadline for you to be able to contribute your portfolio and participate in the 351 exchange.
Is a 351 Exchange Right For You?
The best fit investor profiles would be holding a few positions with large, embedded gains in taxable accounts which are diversified enough to be in line with the 351 rules and have comfort in holding the resulting ETF long term.
351 Exchanges can be a powerful tool in creating a diversified portfolio from highly appreciated stock holdings but speaking to a professional is important here as the process is a bit complex and can’t be undone once completed.
If you think a 351 Exchange may be appropriate for you, please reach out to us to discuss in more detail!
INNOVA is a SEC registered investment adviser. Information presented is for educational purposes only intended for a broad audience. INNOVA is not giving tax, legal or accounting advice, consult a professional tax or legal representative if needed. The opinions expressed herein are those of the firm and are subject to change without notice. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Any opinions, projections, or forward-looking statements expressed herein are solely those of author, may differ from the views or opinions expressed by other areas of the firm, and are only for general informational purposes as of the date indicated. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.