How to Rebalance a Highly Appreciated Portfolio Without Selling: The 351 Exchange Strategy

In today’s episode, you’ll learn more about:

• What a 351 Exchange is and how it works
• The difference between a 351 Exchange and a traditional exchange fund
• Rules investors must satisfy before qualifying
• Which assets qualify and which assets do not
• ETF eligibility requirements
• How highly appreciated ETF portfolios may be consolidated into a diversified ETF
• How concentrated stock positions may fit into a 351 Exchange strategy
• The potential benefits of reducing concentration risk without immediately triggering capital gains taxes
• How 351 Exchanges compare to tax-aware long-short strategies and other tax-efficient diversification techniques

Listen Now:

The Smart Take:

Go Inside the Episode: 

0:00 – Intro

1:32 – What is a 351 Exchange?

6:10 – Key Rules

11:10 – Use Cases

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The Hosts:

Kevin Kroskey, CFP®, MBA – About – Contact

Tyler Emrick, CFA®, CFP® – About – Contact

Episode Transcript:

Tyler Emrick:

Today we’re talking about how to clean up a highly appreciated portfolio without selling. Maybe you’ve accumulated ETFs over the decades. Maybe you’ve got a legacy stock position that you no longer want, or just maybe you’ve got a concentrated stock position that’s become too large. In all three cases, the challenge is still the same. Selling creates a tax bill.

So today we want to discuss the little known strategy called 351 exchanges, how it works, who qualifies, and why it may be one of the most interesting portfolio transition strategies available to you today.

Walter Storholt:

Hey, welcome back to Retire Smarter. I’m Walter Storholt alongside Tyler Emrick, a Certified Financial Planner, Chartered Financial Analyst, and one of the wealth advisors at True Wealth Design, here to help us learn more about the financial world and retire a little bit smarter on today’s episode.

And I think we’re going to do that because we’re covering a topic that I haven’t ever talked about before, Tyler, so I can’t wait to get your expertise here. We’re talking about highly appreciated portfolios, 351 exchange strategies. I got nothing else. That’s what I got. What do you have?

Tyler Emrick:

Hey, anytime we’re starting out throwing out tax code, 351, it might be a little bit of a doozy of an episode today, but you nailed that.

Walter Storholt:

But when it’s tax code that gives us an opportunity, we’re all ears, right?

Tyler Emrick:

You got it. You got it. But yes, so we’re going to be talking about Section 351, which essentially allows you to move certain property or investments into a different vehicle without immediately selling it and realizing a taxable event.

You could think of it as like a 1031 exchange for any of those real estate investors out there that when you… And it’s not lost on me, Walt, of course, that I’m again throwing out another tax code, 1031. So we’ve got a second one here to start off.

But I think that 1031, at least for real estate investors or anybody who has ever had a rental property, hey, you have that for a number of years. You sell it. Hey, if you’ve got some gains there, it’s going to hit your tax return. Well, the IRS code allows you to, if you buy another property within a certain period of time, you can just exchange it and then you defer that gain.

We see it a lot in real estate. The 351 exchange is now you’re able to do it with your other investable securities, which we’ll talk about. So it’s a tremendously valuable strategy, and we really just want to kind of dive into, “Hey, how does this thing work? What are some of the key rules you got to be wary of and who should be really thinking about this for their specific situation?” So really unique, really good. And yeah, we can kind of dive in.

Walter Storholt:

So 1031 is physical property, and 351 is other stocks, security, ETFs.

Tyler Emrick:

Yep, stocks, ETFs are probably going to be your two biggest investments here that you’re doing the 351 exchange into, so absolutely. And there’s another, I guess, terminology that kind of is floated out there as well called exchange funds. Maybe some listeners have heard of that as well.

This is a little different, right? Exchange funds have been around for a number of years. Essentially, that’s where you would exchange these investments for a partnership structure, but they do the same thing. But the problem is, is the exchange funds normally have long lockup periods where you got to leave your money in there for a number of years.

The 351 exchange is much easier. Essentially, you’re taking those highly appreciated investments, stocks, ETFs, and you’re moving it into an ETF, which has immediate liquidity, essentially, which is tremendously impactful and much, much better for a number of individuals than those exchange funds.

But of course, just as anything, Walt, they do have some key rules that we kind of got to be aware of as we think about, “Well, how’s this going to be applicable to your situation?” So it’s a big-

Walter Storholt:

And just so I’m clear, 351 exchange is different than an ETF, which is different than an exchange fund.

Tyler Emrick:

Good question.

Walter Storholt:

ETF is exchange-traded fund, right?

Tyler Emrick:

It is exchange-traded fund, yes. So a 351 exchange actually goes hand in hand with an ETF structure. So high level, what we’re thinking about here is, hey… Let’s use an example. So over a number of years, let’s say you’ve invested in ETFs, you’ve invested in a handful of stocks, and those have done very well for you. So they’ve accumulated in value substantially, and you’re like, “Well, I don’t necessarily want to hold these,” for whatever reason.

Maybe you don’t like the stock any longer. Maybe some of the ETFs that you started with were very specific from an investment standpoint, and you’re like, “I would absolutely sell these, but the problem is, is if I sell them, good old Uncle Sam’s going to get his hands on a piece of it.” So that’s the problem in that scenario.

How the 351 exchange solves that problem is it allows you to take those investments, move them over to an ETF, and that ETF can be a single investment that you have as a line item. So it simplifies things tremendously, and that ETF can have any investment goal that you’d want, right? Maybe it’s an ETF that invests in the S&P 500, or it’s an indexed ETF that invests in a global index.

So you’re able to take those investments you no longer want, shift them over into an ETF that has low cost, has immediate available liquidity, but you gain the diversification that you’re looking for in that scenario. So the 351 exchange is very related to an ETF, but the exchange is what allows you to get the money into the ETF.

Walter Storholt:

Okay.

Tyler Emrick:

Follow me on that?

Walter Storholt:

Yep. I didn’t want to get too far off track, but I thought that background might be helpful for some folks.

Tyler Emrick:

Absolutely, absolutely. So when we think about this transaction and this transfer, of course there’s rules that we need to follow to see if it’s going to be applicable. And those rules oftentimes are in relation to, “Well, what vehicles or what investments are you trying to move over into that ETF?” So there’s oftentimes limitations.

So these limitations read something like, “Hey, no single position can exceed more than a quarter of the portfolio value.” So if you’re trying to take $100,000 of investments, move them over into this ETF through the exchange, no single position can make up more than a quarter of that $100,000, so $25,000 in that scenario. So the rules are oftentimes labeled that way to kind of limit what can be funded into the new ETF that’s being created in this scenario.

So another one would be, “Hey, the top five positions that you’re moving over cannot exceed half of the portfolio value.” So those are just a couple to kind of name a few of the limitations and some of the rules that we need to be aware of on, “Well, hey, is this even applicable in my particular situation? I get the benefit of moving over to the ETF without realizing the taxable event and having to sell investments, but what investments can I actually move over under different scenarios?”

Which brings us to another little rule that we need to be wary of, which is, “Well, what investments can you do this with? What investments can we move the ETFs over in?” So private investments, crypto, RSUs, which are oftentimes in the form of equity compensation through different employers, those cannot be moved over and used as a 351 exchange into an ETF.

Generally, we’re looking at individual stock positions or ETFs. Mutual funds can’t even really be done in this in most cases as well, right? So we are limited to saying, “Well, hey, first thing you need to look at is, ‘Do I have the right investment makeup that I’m trying to diversify out of or move into this 351 move over as a 351 exchange?'” And if you do kind of meet some of those criteria, then, hey, boom, this is perfect. This can really be a good use case for some of the listeners here that are trying to look for that diversification.

So we need to be mindful of the investments that we’re moving over to. Also, some of these funds have minimums as well, right? Sometimes you have to contribute up to $1,000,000 worth of these investments or some gate that you have to get over to be able to participate. And each of these rules can be a little different depending on the company that is actually presenting this opportunity.

So the way this kind of comes to fruition a lot of times, Walt, are big investment houses will say, “Hey, we’re creating a new ETF. We’re going to give families and individuals the ability to move their investments into this ETF through this 351 exchange.” They’ll kind of source it out, and they’ll have a period of time where they’re kind of going out to advisors like ourselves to say, “Hey, do you have any families that would be applicable in this situation that would like to move some investments that have appreciated in value, they want to sell them but they don’t want the tax hit, that we can then move into this ETF? And then they get global market portfolio exposure or diversification or whatever the case may be.”

So normally there’s this subscription period. Once they hit it, they get the assets enough to start the ETF. Then what you’re left with at the end is basically just one ETF share that you own proportionate to the assets that you move over into it. A lot of times these are going to be done through advisors like True Wealth Design where we have those relationships in place to where we can say, “Hey, this family would be perfect for it. Let’s look at it.”

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Walter Storholt:

Yeah. Maybe a standard financial advisory firm might not be going this deep, might not have these opportunities or relationships built, or be interested in even dabbling in this world to help these higher net worth families just because of maybe this specific niche that they service and work with.

But this is where you guys, in working with high net worth families a lot of the time and engineers who get really into probably some of these details, they become very interested in some of these opportunities that I know you’re going to continue to uncover here.

Tyler Emrick:

You got it. So when we kind of get into those use cases, it can get a little niche-y, right? Depending on, one, you have to have the asset base, and really this is for families and individuals where they’ve had investments that have really appreciated in value. Sometimes that takes some time. Now, sometimes it doesn’t, and maybe you’ve got a stock or something like that that kind of rears up and really becomes a big piece of your portfolio.

We do see those use cases, and this 351 exchange is a perfect use case for that particular scenario. But I kind of think of the use case and maybe two different scenarios. We talked about the first one already a little bit, and I kind of think of that as that portfolio cleanup use case where, hey, maybe you’ve been investing over a long period of time. Some investments that you no longer want to hold, specifically stocks or ETFs, have appreciated in value, and you’re really looking to kind of clean those investments up. You don’t want to sell them because you don’t want that tax hit.

So you identify a handful, two handfuls of them. You do this 351 exchange into a new ETF where you’re able to kind of say, “Hey, I want an ETF that’s much more diversified.” Maybe you’re trying to cut down your fees a little bit. Maybe some of the old ETFs that you have higher expense ratios or something like that, and the new ETF that you’re trying to go into, I mean, these have very low costs, right? 15 basis points, 0.15%, are the expense ratios on some of the ones that I’ve seen that have been touted over the last year.

So you could really get into a situation where not only are you cleaning up the portfolio, you’re simplifying the portfolio, but maybe even you’re cutting down on a little bit of your fees as well, depending on what you’re funding these things with. So that portfolio cleanup, I think, is certainly a good use case.

The second one is for those individuals that maybe have those concentrated stock positions that have accumulated over the years, right? Maybe it’s Apple and NVIDIA. Walt, we got SpaceX IPO coming up, I think, in the next week or so. The biggest-

Walter Storholt:

I think it’s stoking a lot of FOMO for folks, right? There’s a lot of emotion and fear of missing out popping up for folks as that momentum builds.

Tyler Emrick:

Is it the biggest? I think it’s the biggest IPO ever, or potentially. If not, it’s got to be up there, market cap size. I mean, the size of the company’s huge, right? When you think about-

Walter Storholt:

There’s a lot of momentum around Anthropic, the claw to AI one that’s coming as well.

Tyler Emrick:

Come into as well. Yeah, it’s going to be a busy year for IPOs, but those individuals that work for those companies that are maybe going to get some of that IPO stock eventually down the road, a 351 exchange might be a good use case for a piece of their portfolio and some of that stock, right? Where they can take that stock and some of their other investments, roll them in together, and put them into an ETF structure to get more diversification without creating a big taxable event.

And the big caveat here too is you’re not really giving up liquidity as well, because you just have a share of an ETF long term after this is all done, right? So you can sell it like any other ETF. Obviously the tax hit would be there, right? But it certainly simplifies things quite a bit, but that concentrated stock position scenario is another big one as well.

I think it’s very closely related to the tax-aware long/short investing that we do also, right, Walt? We’ve done a multitude of podcasts on that in the past, which kind of has a similar use case, right? We’re trying to solve a problem of investments that have appreciated in value, trying to solve a problem of investments that have appreciated in value, good problem to have.

Walter Storholt:

Good problem to have.

Tyler Emrick:

A very good problem to have. But if you are sitting there and you’re trying to accomplish something different, whether it be diversification, whether it be liquidity and trying to get access to some of those funds, a little more tax efficiency, the 351 exchange and the tax-aware long/short strategy almost work in tandem or could both be a piece of that answer as you think about your situation and diversifying out of some of these highly concentrated positions.

They work a little differently, right? The 351 exchange is maybe a little less complex. Your end-game result is a little more simplified because you just have a share of an ETF that you have long term. The tax-aware long/short certainly has a little more complexity, a little more positions, but maybe a little bit more advantages in the form of liquidity and diversification.

And frankly, some of our solutions for some of the families that are using tax-aware long/short for a long period of time, some of the solutions are going to be taking some of those end highly appreciated positions and moving them over and doing a 351 exchange to an ETF, so that way maybe they’re cutting down fees or something like that over the long run.

So these strategies can be used in tandem. They could both be a piece of the solution that you’re looking for for those individuals that have had those highly appreciated positions. So fun stuff. I mean, with some of the tax law changes and some of the technology changes, having the ability to do these 351 exchanges, doing tax-aware long/short, I mean, you have a multitude of solutions available to you to kind of solve some of these longstanding problems of appreciated positions in the tax hit that they potentially provide down the road.

I think they’re great use cases and great solutions for the right individual.

Walter Storholt:

Yeah, it’s a great point. It’s another tool in the toolbox that you can find some specific uses for. It reminds me of a tool my dad gave me a couple of years back. It wasn’t an essential tool, I could still fix stuff around the house without it, but just kind of like this, you could probably survive and get to retirement and do okay without ever knowing about a 351 exchange, but it introduced a new opportunity. It might save you time, energy.

This new tool, it was a magnet at the end of a very, very long extension rod, and the whole point of the tool, I guess, is if you drop a screw in a hard-to-get-in place, you can just take this little extension wand and… He thought it was the coolest thing ever, and I was like, “I can’t think of specific use cases where this is going to happen, but one of these days I’m going to go use that and be happy about it.”

Tyler Emrick:

And it’s going to be perfect.

Walter Storholt:

I feel like that’s the 351 exchange in a way of, it’s a really neat tool to have on hand for when it’s the right fit for your situation. And it’s not going to fit everybody by any means or be something you use every single day in your specific situation, but when there’s that time and it comes up, boom, here’s a tool that can solve some of these problems, some of these good problems to have.

Tyler Emrick:

Oh, absolutely. And the outcome can be outsized as well, right? Very niche, but the outcome of using the 351 or a tax-aware long/short strategy for families that need it.

Walter Storholt:

Hey, I recovered the screw and don’t have to go back to Lowe’s to buy new ones.

Tyler Emrick:

You nailed it.

Walter Storholt:

Anyone that does projects at home knows that’s a big win to not have to go back to Lowe’s for the eighth time.

Tyler Emrick:

I’m guilty of that for sure. Yeah, no, it makes perfect sense.

Walter Storholt:

Awesome. Well, hey, very fun episode, interesting to learn about this. I know those who think that they might be in this scenario and a good fit for some of those examples that you laid out for us are probably going to be interested in talking to you a little bit further about that.

And so if that’s you and you want to talk a little bit more about 351 exchanges, how that might fit into your portfolio and your situation, the team at True Wealth Design is here to help. It’s very easy to touch base and see if you’re a good fit to work with one another. All you have to do is click the link that’s in the description of today’s show or go to truewealthdesign.com and click the Let’s Talk button.

Either way, that’ll get you there, and you can schedule a 20-minute discovery call with an experienced advisor on the team, see if you’re a good fit, and then go from there. It’s easy and free to do that, so don’t hesitate to reach out if you’ve got any questions about this or anything else we talk about here on the show.

Tyler, thanks so much for your help and wisdom on this topic, and we’ll talk again soon.

Tyler Emrick:

Absolutely. Catch you on the next one.

Walter Storholt:

All right. We’ll see you soon. That’s Tyler and Walter. We’ll see you again right back here on Retire Smarter.

Speaker 4:

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