A century-old tax code provision is quietly re-emerging valuable tool in modern wealth management. For investors with highly appreciated stock, the Section 351 ETF exchange may be a strategy worth considering.

Picture this: You’ve held shares of a single company for decades — perhaps a former employer, a family inheritance, or an early bet that paid off spectacularly. On paper, you’re wealthy. But sell those shares and a substantial portion of those gains disappears immediately to the IRS. So you hold on, watching your financial future remain tethered to the fate of one company, one board of directors, one quarterly earnings report.

For years, this was the trade-off sophisticated investors simply accepted. Not anymore.

A provision buried in the tax code since 1921 — Section 351 of the Internal Revenue Code — is quietly reshaping how the wealthiest Americans manage concentrated stock positions. And thanks to the rapid evolution of the ETF marketplace, this strategy is now more accessible than ever. Between 2021 and 2025, 39 U.S. ETFs launched with approximately $8.7 billion in seed assets from individual investors using this approach. This is no longer a niche technique reserved for the ultra-wealthy. It is a mainstream tool — and it is accelerating.

What Is a Section 351 ETF Exchange?

At its core, a Section 351 exchange allows an investor to contribute appreciated securities to a newly formed exchange-traded fund (ETF) in exchange for shares of that fund — without recognizing a taxable gain at the time of the transfer. The investor’s original cost basis carries over into the ETF shares, deferring the tax obligation until those shares are eventually sold.

This is not a loophole or a gimmick. Section 351 was originally designed to let business owners contribute appreciated assets to a corporation without triggering a taxable event — a corporate formation tool that has been a feature of the tax code for over a hundred years. Based on guidance from the IRS, wealth managers across the country are now using it on behalf of clients, and the trend is only growing.

The mechanics work like this: investors contribute a diversified basket of appreciated securities to a newly formed ETF. Each investor’s contribution must meet specific IRS diversification tests — no single holding can represent more than 25% of the portfolio being contributed, and the top five positions cannot exceed 50% of the portfolio’s net asset value. Investors must also hold sufficient control of the new fund, generally over 80% of vote and value, upon its launch. When those conditions are satisfied, the contribution is treated as a non-taxable event.

The Tax Benefits Are Exceptional

For investors in highly appreciated positions, the financial math is compelling. Consider a scenario where an investor holds $2 million in a single stock with a cost basis of $200,000. A traditional sale triggers immediate capital gains tax on $1.8 million of gain — potentially $400,000 or more gone before a single dollar is reinvested.

Under a Section 351 exchange, that same investor contributes the shares to an ETF and receives fund shares in return. No capital gains tax is owed at the time of the exchange. The tax is deferred until the ETF shares are sold — and if those shares are held until death, heirs may receive a stepped-up cost basis, potentially eliminating the embedded gain entirely. That is not a deferral. That is permanent tax elimination.

Even for investors who eventually sell their ETF shares, the deferral itself carries enormous value. Tax dollars that remain invested continue to compound — often for decades. The ETF structure further extends this advantage: because ETFs typically use in-kind creation and redemption of shares, they rarely distribute capital gains to shareholders. Once inside the ETF wrapper, assets can be rebalanced and reallocated with minimal additional tax impact.

Instant Diversification Without the Pain

Beyond the tax advantage, the more immediate practical benefit is something concentrated investors rarely achieve: genuine diversification. Holding a single stock — no matter how strong the company — exposes an investor to company-specific risk that no amount of conviction can fully justify. Earnings misses, regulatory changes, management turnover, sector rotation — any of these can devastate a concentrated position in ways a diversified portfolio would absorb without incident.

The ETF received in a 351 exchange is typically a diversified fund holding dozens or hundreds of securities. In a single transaction, an investor moves from single-stock risk to broad market exposure. For investors approaching retirement — or those who simply cannot afford to see decades of accumulated wealth evaporate in one bad quarter — this is transformative.

Behavioral finance research consistently shows that investors holding concentrated positions make suboptimal decisions driven by attachment, familiarity bias, or overconfidence in a single name. Diversifying into an ETF removes that psychological burden and replaces it with a professionally managed, rules-based investment structure.

Why the Timing Has Never Been Better

For most of its history, the Section 351 strategy was the exclusive domain of large wealth management firms that could afford to create private ETFs for their clients — a costly and operationally complex undertaking. That barrier is falling rapidly.

A new generation of publicly available ETFs designed specifically to accept 351 contributions is opening the strategy to a much broader investor base. Rather than creating their own proprietary fund, advisors can now direct eligible clients into these established ETFs, dramatically reducing the cost and complexity of participation.

Morningstar senior analyst Daniel Sotiroff has publicly stated that he expects the trend to accelerate. For investors with taxable accounts loaded with embedded gains, Section 351 exchanges solve a problem that traditional tax strategies — tax-loss harvesting, charitable giving, installment sales — simply cannot address at scale. Unlike exchange funds (which impose a seven-year lockup) or opportunity zone investments (which require deployment into specific assets), ETF shares are publicly traded and can be sold at any time. The flexibility is unmatched.

Who Is Best Positioned to Benefit?

This strategy works best for investors who check several boxes:

•        Large embedded gains in a taxable account — typically $500,000 or more in appreciated securities

•        A long time horizon or estate planning goals where a stepped-up basis could eliminate the gain entirely

•        A diversified enough portfolio of appreciated securities to meet the IRS’s 25/50 diversification tests

•        A desire to move from single-stock risk to professionally managed, diversified exposure without triggering a tax event

It is equally important to understand what the strategy is not. It is not a mechanism for avoiding taxes permanently on its own — the gain is deferred, not forgiven, unless held through an estate. It is not suitable for investors who need immediate liquidity from a sale. And it requires careful structuring with qualified legal and tax counsel to ensure the transaction meets all IRS requirements. The Morningstar analysis that brought widespread attention to this strategy also flagged patterns — such as “stuffing” an ETF with assets that don’t fit its stated strategy, or repeatedly creating new funds solely to cycle appreciated stock — that could invite regulatory scrutiny. Working with experienced advisors who structure transactions appropriately is essential.

The Bottom Line

There are not many moments in financial planning where the tax code and sound investment strategy align perfectly. The Section 351 ETF exchange is one of them. It allows investors to step out of concentrated, risky positions, gain broad market diversification, and do so without handing a substantial portion of their hard-earned gains to the federal government in the year they make the move.

After decades in which this strategy was available only to institutional players and ultra-high-net-worth families with private ETFs, the democratization of the 351 exchange is one of the most significant developments in tax-efficient investing in recent memory. The window is open. The question is whether you are positioned to walk through it.

If you hold a substantial appreciated position and have wondered whether there is a better path forward, now is the time to have that conversation.

This post is for informational purposes only and does not constitute tax or investment advice. Consult a qualified tax advisor or financial professional before implementing any investment strategy. New South Wealth Management is an independent wealth management firm affiliated with Cambridge Investment Research.