An option to move away from individual stocks to diversified alternatives without immediate tax hit
Sid Roy
28 March 2026
With stock valuations soaring over the past few years, investors holding significant positions in individual stocks face a dilemma: whether to keep their portfolios concentrated or diversify into the broader market.
The decision isn’t easy. On one hand, concentrating on a few companies exposes you to substantial risk and the possibility of missing out on broader gains. On the other, shifting to a more diversified portfolio can trigger a significant tax liability if it requires selling existing holdings. As such, most people would diversify if not for the hefty tax bill.
We get this question quite often, and exchange funds tend to come up as a possible solution. One of our principles is not to form investment opinions on things we don’t fully understand. In our March 2026 Ask–Learn–Share session, we explored exchange funds out of curiosity and shared our notes. As with any investment vehicle, they’re not a silver bullet and deserve careful consideration.
What Is an Exchange Fund?
An exchange fund does exactly what the name suggests: it allows you to exchange existing stocks for shares in a diversified fund, effectively contributing your holdings in kind. This provides a mechanism to diversify a concentrated portfolio without triggering taxes during the transition.
For this article, we focus specifically on Section 351 Exchange ETFs (Exchange Traded Funds), named after the IRS tax code that underpins these structures. As an aside, Section 721 Exchange Funds operate differently and should not be confused with Section 351 funds.
Who is it for?
If a large portion of your portfolio is concentrated in a small number of highly appreciated individual stocks held in a taxable brokerage account, and if tax costs are preventing you from diversifying and reducing risk, a Section 351 Exchange ETF may offer a viable alternative.
This situation is not limited to corporate executives or founders with large stock positions. It also applies to employees of highly successful companies who have accumulated company stocks over time as part of their compensation.
More broadly, investors who have pursued active stock-picking strategies may find themselves in a similar position. After accumulating substantial unrealized gains, transitioning to a simpler, diversified portfolio of low-cost funds can become prohibitively expensive from a tax perspective.
How 351 Exchange ETFs Work
At a high level, IRS code 351 allows investors to contribute appreciated securities (stocks, narrow ETFs, and so on) to a diversified pooled investment without triggering any capital gains taxes, provided that certain conditions are met. In exchange, you get units of share in a newly formed ETF, comprised of the contributions from similar investors in your shoes.
For all intents and purposes, you participate as an investor in the inception of the new ETF. The fund’s formation is orchestrated by the fund sponsor with an initial pool of investors contributing their stocks, just like any other pooled investment fund. The difference is the contribution in kind.
To break down the process:
Proposition: Fund company proposes to form a new 351 Exchange ETF that either mimics a broad stock index like S&P 500, or a diversified universe of stocks. Fund sponsors seek in-kind contributions from qualified investors such that the aggregate pool of stocks from all potential investors satisfies the investment objectives of the proposed fund.
Contribution: You (and other investors) contribute your existing stocks towards the inception of the newly formed ETF.
Swap: In exchange, you receive shares of the newly formed ETF.
Tax Deferment: Per IRS Section 351 tax code, this swap is not considered “sale.” Therefore, you don’t owe any tax at the time of the exchange. However, the aggregate cost-basis of your contributing stocks carries forward and becomes *your* cost-basis of the newly received fund shares.
What are the benefits?
The primary benefit is the ability to transition from a concentrated portfolio to a diversified investment approach without incurring immediate taxes.
Investment concentration can turn lucky investors wealthy sooner than expected. Preserving that wealth, however, typically requires diversification and risk reduction. A Section 351 Exchange ETF enables this transition in a tax-deferred manner.
Note that it does not get you off the hook from paying taxes. You are still liable to pay taxes when you eventually sell the shares of the new fund. Tax is deferred, not eliminated. You simply avoid having to pay all the taxes upfront during your diversification process.
Does every one of us qualify?
While these ETFs trade publicly after launch just like any other public ETFs, the tax-deferral swap is available only to the investors who participate in the initial seeding or inception of the ETF. Since the fund seeding is a highly coordinated effort, participation is typically accessed only though specific advisors approved by the fund sponsor.
Furthermore, these ETFs often require a large minimum contribution, which effectively limits the participation to high net-worth investors only.
Any restrictions on the swap?
Though the 351 Exchange ETFs feel like a convenient get out of jail card for anyone having large individual stock holding, there are important caveats that determine the extent of swap. Specifically, the 25/50 rule of Section 351 requires that your overall in-kind contributions must be reasonably diversified. No single stock in your contribution can exceed 25% of your total contributions. Similarly, the top 5 stocks in your contribution must add up to less than half of your total contribution. Therefore, you can’t simply get rid of a small number of highly appreciated stocks unless you also contribute enough other stocks to meet the 25/50 rule.
Is it right for me?
If you do have individual stock positions that meet the 25/50 criteria mentioned above and you are considering a 351 Exchange ETF, your decision should depend on a few factors.
First, you have to understand the investment objectives of the candidate ETF and determine whether it’s an appropriate long-term investment for you, even when no in-kind exchange is involved. Is the new fund diversified enough, or is it simply a narrow fund holding only a small number of similar stocks?
For example, swapping your basket of ten technology stocks for a fund mimicking the S&P 500 Index is a reasonable diversification. But if the new fund is going to invest only in a handful of technology stocks, the diversification benefits may not be fully realized as you’re still going to be concentrated largely in the technology sector. The new fund must be a solid core investment of your portfolio by its own merits, not simply because it’s 351 Exchange ETF.
The second factor is the investment cost. Broadly diversified passive funds are excellent choice for long-term holding due to their low fees. If a similar 351 exchange ETF is going to cost much more, then it’s bound to lag its low-cost counterpart. Furthermore, most new 351 ETFs are accessible only through an advisor, implying additional cost on top of the fund management fee. Higher ongoing management cost will likely erode the tax-deferral benefits of the exchange fund over time.
Conclusions
A Section 351 Exchange ETF is a specialized tool that allows investors to diversify concentrated stock positions without triggering immediate taxes. However, it comes with complexity, restrictions, and potentially higher costs.
Before pursuing this route, it is worth considering whether simply realizing gains and reinvesting in a low-cost diversified portfolio may be the more straightforward and ultimately more effective option.
While keeping taxes low is a fine goal, investment policy should not be dictated solely by tax considerations