Picture this: you’ve held a stock for 20 years, and now it’s worth millions. Yet your cost basis is almost nothing, but selling triggers a massive tax bill, so you hold.

That’s the trap millions of long-term investors face. The more successful the investment, the more painful the exit.

But a growing number of wealthy Americans have found a way out. They’re not selling, they’re not donating, but they’re seeding brand-new ETFs with their appreciated stock and walking away with diversified fund shares.

Here’s what you need to know before this door potentially closes

Morningstar identifies 39 ETFs seeded with $8.7 billion in appreciated assets.

The strategy is called a Section 351 exchange. A new Morningstar analysis based on research by Brent Sullivan and Elliot Rozner reveals how fast it’s growing. Between 2021 and 2025, 39 U.S. ETFs launched with roughly $8.7 billion in seed assets from individual investors.

This is no longer a niche technique. Wealth managers are transferring clients’ concentrated, low-basis stocks into newly formed ETFs. The investor receives ETF shares in return. No gain is recognized at the time of transfer if the exchange satisfies Section 351 requirements.

The appeal is straightforward: you reposition appreciated holdings into a diversified strategy. You avoid an immediate capital gains event. You access the structural tax benefits of the ETF wrapper, including in-kind redemptions that minimize future fund-level realizations.

How Section 351 lets investors swap stock for ETF shares tax-free

Section 351 of the Internal Revenue Code dates back to 1921. Congress created it to help small business owners incorporate without triggering a taxable event. The rule says you can transfer property to a corporation in exchange for stock, tax-free, if the transferors collectively own at least 80% of the new entity.

Wealth managers realized this old rule applies to ETFs. A client contributes a portfolio of appreciated securities to a newly created ETF before launch. The client receives ETF shares, and the cost basis carries over.

The basic mechanics:

  • The investor transfers stocks from a taxable account into a brand-new ETF.
  • The investor receives ETF shares with their original cost basis.
  • The ETF manager later rebalances into a target portfolio using in-kind transactions.
  • Capital gains are deferred until the investor eventually sells the ETF shares.

Once inside the ETF wrapper, the manager can rebalance without triggering gains for shareholders. The ETF’s in-kind creation and redemption mechanism handles that. It’s a double layer of tax efficiency stacked on a single transaction.

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The strict diversification test you must pass to qualify

Section 351(e) includes a critical guardrail. The tax-free treatment is denied if the transfer results in “diversification” of the investor’s interests. Treasury regulations enforce this through what’s known as the 25/50 test.

The 25/50 diversification rules:

  • No single stock can represent more than 25% of the assets you contribute.
  • Your top five holdings cannot exceed 50% of total contributed assets.
  • Cash is excluded from the calculation.
  • ETF holdings are evaluated on a look-through basis

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If your portfolio is already diversified, the exchange qualifies. If it’s concentrated in one or two stocks, it doesn’t. You can’t dump $10 million of Nvidia into an ETF and call it a 351 exchange, as CNBC reported; the portfolio must meet the test at the time of contribution.

The investors and firms driving the $8.7 billion wave

This strategy is not for everyday retail investors, as minimum contributions typically start at $1 million. Alpha Architect, one of the early movers, recommends a minimum portfolio of that size. Cambria Funds’ first 351-seeded ETF, launched in December 2024, carried the same floor.

Large wealth management firms create private ETFs via 351 conversions for their clients. Smaller firms now participate through publicly traded ETFs. Recent launches include Stance’s Sustainable Beta ETF (November 2024), Cambria’s Tax Aware ETF (December 2024), and Longview’s Advantage ETF (February 2025).

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Morningstar senior analyst Daniel Sotiroff told CNBC he expects the trend to accelerate. For investors with taxable accounts full of embedded gains, 351 exchanges solve a problem that traditional tax-loss harvesting can’t fix.

The IRS is paying attention, and so is Congress

The tax-free treatment is not guaranteed. Morningstar’s analysis flags two aggressive patterns that could invite IRS scrutiny.

Red flags the IRS is watching:

  • “Stuffing”: Packing a new ETF with highly appreciated assets that don’t fit the fund’s stated strategy.
  • “Sequential seeding”: Repeatedly creating new ETFs solely to cycle appreciated stock into tax-deferred wrappers.

Both patterns could lead the IRS to re-characterize the transaction and impose immediate capital gains tax. The agency has broad authority under the economic substance doctrine to challenge transactions that lack business purpose beyond tax avoidance.

Congress has noticed too. Senator Ron Wyden introduced legislation aimed at limiting 351 exchanges’ access to ETFs, Bloomberg reported. The U.S. Treasury Department held early discussions with the Investment Company Institute about potential guidance. Wyden called the strategy a loophole that Congress has tried to close at least three times before.

How the loophole becomes permanent through the step-up in basis

Here’s the part that makes tax experts uneasy. If you defer gains through a 351 exchange and hold those ETF shares until death, your heirs receive a stepped-up cost basis under current law. The embedded gain disappears entirely. No one ever pays the tax.

Under Section 1014 of the Internal Revenue Code, inherited assets reset to fair market value at the date of death. Combined with the 351 exchange, this creates a pathway from concentrated stock to diversified ETF to tax-free inheritance.

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Morningstar’s analysis quotes a 1999 congressional press release comparing these strategies to “a phoenix rising from the ashes.” Each time Congress closes one path, the industry finds another. The ETF seed is the latest version.

What this means if you’re sitting on large unrealized gains

You probably don’t have $1 million in a single taxable account. Most readers don’t. But the mechanics of this strategy still matter to you, for two reasons.

Why everyday investors should pay attention:

  • If Congress restricts 351 exchanges, the broader ETF tax advantage (in-kind redemptions) could also come under scrutiny. That affects every ETF you own.
  • If you hold concentrated positions from stock compensation, startup equity, or long-term holdings, smaller-scale versions of this concept may eventually reach lower minimums.
  • Understanding how the wealthy defer taxes helps you pressure-test your own tax strategy. If you’re paying more than necessary, a conversation with a tax advisor is worth the fee.

The standard ETF tax advantage already works in your favor. U.S. stock ETFs avoided tax on more than $211 billion in gains in a recent year, Bloomberg found. That’s not just for the ultra-rich. Every time you hold an S&P 500 ETF that distributes zero capital gains, you benefit from the same structural feature.

The risks you should weigh before assuming this strategy is safe

The 351 exchange is legal today. Whether it stays fully intact depends on regulatory and legislative action that is already underway. Here are the practical risks, whether you’re considering the strategy directly or evaluating ETFs that were seeded this way.

Key risks to consider:

  • IRS recharacterization: If the agency determines a 351 exchange lacks economic substance, the investor owes capital gains tax retroactively
  • Legislative risk: Pending proposals from Senator Wyden and Treasury discussions could narrow or eliminate the strategy
  • Liquidity lock: Once your assets are in the ETF, you can’t easily pull them out. Selling ETF shares triggers the deferred gain.
  • Rebalancing lag: Newly seeded ETFs can take up to 12 months to fully align with their target allocation, per Kitces.com research
  • High minimums: Most publicly traded ETFs require $1 million or more to participate

CFP Charles Sachs of Imperio Wealth Advisors told CNBC he avoids the strategy because it limits client flexibility. Once you’re inside, switching strategies is difficult without triggering the very gains you deferred.

Related: Vanguard Dividend ETF quietly outperforms amid market panic

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