Capital Gains and ETF Conversions: What You Need to Know

In light of the recent stock market growth, many investors find themselves with significant profits in taxable accounts. This can lead to noticeable capital gains when they decide to sell.

This situation is particularly relevant for wealthier Americans, who face a top capital gains rate of 20% along with a 3.8% Net Investment Income Tax depending on their overall income.

One potential approach, referred to as 351 conversion or exchange, enables high earners to transform their valuable assets into stocks within new exchange sales funds. Strategy Seed observes that ETFs can be structured before their official launch, allowing the initial investors to defer recognition of capital gains until they sell their stocks.

For some, this approach feels almost “magical,” says David Haas, president of Celeus Financial Advisor in Franklin Lakes, New Jersey.

Insights on ETF Strategies

Regarding ETF structures, a key benefit is that fund managers can accept assets before the fund officially opens and can adjust their positions later without realizing profits.

While the number of ETF alternatives has been rising, the available public options remain fairly limited, according to experts.

Haas utilizes 351 conversions for specific clients but acknowledges that there are important considerations to keep in mind. Here are some critical points to consider.

Understanding ETF Conversion

A number of high-income individuals still invest in separately managed accounts (SMAs), which are tailored taxable portfolios managed actively. One attractive feature of SMAs is tax-loss harvesting, where losses are used to counterbalance portfolio gains. However, Daniel Sotirov, a senior analyst at Morningstar Research Services, notes that these opportunities tend to “decrease over time” as asset values increase.

He suggests that ultimately, “there are few losses to harvest,” and making changes to investments will likely trigger capital gains.

For some investors, converting to an ETF via 351 could be a viable solution to these challenges.

Large financial planning firms managing client SMAs now have the option to create private ETFs through 351 conversions. Recently, even smaller businesses or SMAs have begun participating in public ETFs.

“I wouldn’t be surprised if this trend continues,” Sotirov commented.

Still, the barriers for entry remain high. For instance, Alpha Architect suggests a minimum investment of $1 million, while Cumbria’s funds feature a similar threshold for their first 351 ETF conversion launching in December 2024.

Understanding Diversification Requirements

The option to defer capital gains tax on inherent profits can be appealing, yet certain stipulations apply to converting 351 to ETFs, according to experts.

“You can’t exchange one asset for a 351 exchange and expect deferred tax treatment,” explains Ben Henry-Moreland, CFP at Advisor Platform Kitces.com. “There are strict diversification requirements that must be met for tax deferral.” Transferred assets must be deemed “diversified” under specific conditions:

• No single share or company should represent more than 25% of the transferred assets.
• The five largest assets should not account for more than 50% of the total donated assets.

Additionally, certain asset classes, including mutual funds and alternative investments like private equity and cryptocurrencies, might be restricted from transfer, as Henry-Moreland pointed out in a previous discussion about 351 exchanges.

Considering the “Stuck” Factor

Before opting for the 351 conversion, investors should carefully weigh the pros and cons, particularly how it aligns with their overall financial strategy. Exchanging assets for ETF shares can lead to implications that may diverge from original investment goals.

Charles Sachs, a chief investment officer at Imperio Wealth Advisors in Florida, expresses hesitance about utilizing this strategy, citing that it might limit clients’ options. “You can do that, but you’re effectively trapped,” he noted.

Haas from Cereus Financial Advisors remarked that while 351 conversions are possible, “not many companies are engaging in this.” And if clients do decide to sell, capital gains could surface.

“It’s critical to think through all of this,” he added. “You need to feel comfortable with the ETF.”