Few planning tools solve as many problems at once as a 351 exchange. Investors sitting on highly appreciated stock have long faced a hard choice: hold an aging, hard-to-manage book of positions, or sell and hand a large share of the gains to the IRS. A 351 exchange offers a third path. Investors contribute those holdings in-kind to a newly launched ETF, receive ETF shares in return, and defer the capital gains tax, while gaining professional management, daily liquidity, and the ongoing tax efficiency of the ETF structure.
Done right, the process turns years of accumulated tax lots, direct-indexing sleeves, and legacy positions into a single, diversified holding. And after this week’s guidance, investors and advisors have something they lacked before: a written IRS standard for what a legitimate 351 launch looks like.
On September 28, 2026, the IRS began to draw a line in the sand on “potentially abusive” ETF tax strategies, 351 exchanges, and box spreads when they released Notice 2026-62 and Revenue Ruling 2026-20. The question is can you still do 351 exchanges? The answer is yes but only when the contributed securities fit the fund’s strategy and are meant to stay in the fund. That is the practical line Treasury and the IRS drew with their most recent notice.
The importance of these new pronouncements can’t be overstated as more than 100 ETFs have been launched via Section 351 since 2021, with over $20 billion in combined seed assets, according to InvestmentNews. In this article, we weigh the pros and cons of 351 exchanges in light of the new guidance and explain what this means for ETF investors.
Explaining 351 Exchanges:
A 351 exchange lets investors contribute appreciated securities to a new ETF in return for shares in that ETF, without having to recognize a gain on the transfer. The investor’s original cost basis carries over to the ETF shares, so tax is deferred until those shares are sold.
A Step-by-Step Look at the Strategy:
1
A sponsor files for a new ETF and sets a seeding date.
2
Investors contribute in-kind portfolios (individual stocks, ETFs, and/or mutual funds cannot be contributed).
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The new ETF issues shares. The contributors, as a group, must own at least 80% of the new ETF immediately following the initial exchange.
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The new ETF manages its portfolio going forward, using in-kind redemptions under IRS Section 852(b)(6) (which permits an ETF to distribute appreciated property to redeeming shareholders without recognizing capital gains) to shed low-basis positions over time.
The Core Requirements For a 351 Exchange, per Advisor Perspectives:
| Requirement | Rule |
|---|---|
| Single-issuer cap | No one issuer can be above 25% of each investor’s contributed assets. |
| Top-five position cap | The five largest positions combined cannot exceed 50%. |
| Control | Contributors to the ETF must own at least 80% of shares immediately after contributing. |
| Timing | Available only at launch. Later inflows cannot use 351. |
What the New Guidance States
The guidance separates “seed and hold” 351 launches from “seed and swap” conversions, with the tax treatment of the former remaining unchanged while the latter is now taxable.
Revenue Ruling 2026-20 addresses a specific pattern: an investor contributes an appreciated portfolio to a new ETF, an authorized participant (AP) buys in with different securities or cash, and the ETF soon redeems the AP using the investor’s original assets. Applying the step-transaction doctrine and treating the ETF as a mere conduit, the IRS holds that the investor made a taxable Section 1001 exchange with the AP, not a Section 351 transfer. The fact that the redemption qualifies under the previously mentioned IRS section 852(b)(6) fails to rescue the plan.
Notice 2026-62 takes a wider view. It describes the 351 conversion pattern as combining Sections 351 and 852(b)(6) “to achieve a result that neither provision was designed to produce,” and also flags related tax strategies such as:
- Box spread funds that earn T-bill-like returns through options and redeem appreciated options in-kind, so holders avoid current ordinary income (the BOXX model).
- Partnership structures used to transfer undiversified stock into a 351 conversion.
- Funds that rotate between same-index ETFs around dividend record dates.
- Commodity and digital-asset ETFs that use in-kind redemptions to pass the Regulated Investment Companies (RIC) income test.
- Tax-aware long/short strategies using straddles, currency elections, and swap terminations.
We believe there are three main points investors should consider when weighing a 351 exchange:
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The safe lane is explicit: Notice 2026-02 explicitlydoes not address a 351 transaction “used to seed a newly established ETF with assets that are consistent with the ETF’s investment thesis and that are intended and expected to be retained by the ETF absent a substantial change in circumstances (including an unexpected change in market or business conditions).”
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Retroactivity is on the table: Any further guidance “could apply prospectively only or retroactively to transactions that already have taken place at the time the guidance is issued.”
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Comments are due October 28, 2026: The Treasury Department is weighing the issuance of additional rules, so the line could still move.
Pros
The benefit of the updated guidance is it maintains the core benefit of a 351 exchange, thereby permitting investors to defer gains on a concentrated or unwieldy portfolio.
Other potential benefits include:
- Tax deferral on appreciated holdings: Investors can move into professional management without selling and paying capital gains tax up front. Basis carries over, so tax is only due when the ETF shares are sold.
- Ongoing ETF tax efficiency: Once inside, the ETF can use in-kind redemptions under IRS section 852(b)(6) to purge low basis lots over time. This typically limits capital gain distributions. Rev. Rul. 2026-20 leaves ordinary-course redemptions alone.
- Simplification: Hundreds of legacy lots, direct-indexing sleeves, or tax-loss-harvested accounts come under one ticker with daily liquidity and relatively simple reporting.
- Step-up planning: Because tax is deferred, not forgiven, shares held until death may receive a basis step-up.
- Clearer rules than a week ago: The IRS has now said in writing that retained contributions are outside its concern, which provides sponsors and advisors a defensible standard.
Cons and risks
The most significant new risk is recharacterization. This can happen when an ETF launch appears to be a “seed and swap,” which can result in an investor’s contribution being treated as a taxable sale. For example, contributions that are quickly redeemed out to an AP, leaving the ETF with a materially different portfolio, are taxable Section 1001 exchanges; the timing of “shortly thereafter” an ETF launch is a key red flag.
Other potential risks include:
- Possible retroactive guidance: The Treasury’s notice reserves the right to apply its position to previous launches, therefore, previous conversion-style launches carry open tax exposure until further guidance is issued.
- Less portfolio flexibility: The ETF should not have a pre-arranged plan to dispose of contributed assets beyond ordinary operations. A manager who wants to overhaul the book immediately after launch now invites scrutiny.
- Diversification is still required: Truly concentrated positions (one stock over 25%, or top five over 50%) cannot be contributed alone. The notice also targets partnership workarounds used to get satisfy this test.
- Deferral, not elimination: Carry over basis means the embedded gain is still there. Selling the ETF shares triggers the capital gain.
- One-time window and fund risk.:351 exchanges only work at launch. Investors necessarily take on a new ETF’s manager, fees, and the risk it fails to gather assets or later closes, which can force a taxable event.
- Cost and complexity: ETF launches need legal, tax, and operational work, and each investor’s contribution must be reviewed for eligibility.
Who it fits, and what to check
A 351 exchange makes the most sense for a long-term investor who holds a diversified and appreciated portfolio that is similar to the target ETF’s strategy.
| Profile | Fit after the guidance |
|---|---|
| Diversified, appreciated equities that match the ETF’s mandate and that the investor plans to hold | Strong, potentially in the safe lane |
| Direct-indexing or tax-loss-harvested accounts tracking a similar index | Reasonable, if holdings overlap the fund’s thesis |
| Portfolio that differs from the target ETF’s strategy and would be traded out soon after fund launch | Weak, the type of pattern that Rev. Rul. 2026-20 taxes |
| One or two concentrated stocks | Not eligible alone and partnership workarounds are flagged |
Before committing to a 351 exchange, investors and advisors should ask:
- Does the new ETF’s stated strategy match what I am contributing?
- Does the sponsor expect to keep most contributed positions, and how fast will it rebalance after launch?
- Are there prearranged AP trades or redemptions around the seeding date?
- Has tax counsel reviewed the launch against Rev. Rul. 2026-20?
- What happens to my position if the ETF closes at a later date?
Bottom line: the revised guidance clarifies, rather than ends, 351 exchanges. Thesis-consistent, hold-oriented launches retain their tax deferral, whereas conversion trades built to swap portfolios tax-free now carry real risk (even on a retroactive basis). With comments due October 28 and additional rules possible, anyone considering a launch in the coming months should build in time for updated advice.
About Strategy Shares
Strategy Shares is a family of exchange traded funds (ETFs) focused on bringing alternative strategies to the ETF marketplace. The firm strives to provide innovative strategies that support investors in meeting the challenges of an ever-changing global market environment. For more information on Strategy Shares and its various offerings, please visit: www.strategysharesetfs.com.
NOTICE:
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