The US Treasury Department is scrutinizing at least 87 investment funds that used Section 351 exchanges to avoid immediate capital gains taxes, managing roughly $18 billion in assets. This review could disrupt a popular tax strategy that lets investors defer hefty tax bills by swapping appreciated stocks into ETFs.
How Section 351 exchanges work
Section 351 of the Internal Revenue Code allows investors to transfer appreciated securities into a newly minted corporation, like an ETF, in exchange for shares without triggering a capital gains tax right away. Essentially, if you bought stocks years ago that have surged in value, instead of selling them and paying taxes, you can contribute those stocks to an ETF through this exchange. Your cost basis carries over, delaying tax obligations until you sell ETF shares.
This tactic took off around 2021 when soaring market gains left investors sitting on large unrealized profits. Financial advisors combined this old tax code provision with ETF structures known for tax efficiency, creating a powerful tax-deferral tool. However, limits exist: no single security can make up more than 25% of the assets going into the fund, and the top five combined can’t exceed 50%.
Regulators challenge the strategy
Concerns surfaced as early as February 2026, with Treasury officials questioning if these transactions align with the intended tax rules. At a Wall Street Tax Association seminar, regulators openly debated whether this approach is 'too good to be true.' The Investment Company Institute has since met with Treasury multiple times pushing for clearer guidance.
The issue stems from overlap between these Section 351 deferrals and ETFs’ existing in-kind creation and redemption tax benefits. If the strategy is deemed abusive, it could force funds and investors to face significant tax bills, reshaping tax planning in the ETF space.
This material is informational and does not constitute financial advice.
