Raymond Holst

Ray Holst is a tax attorney at Practus, a fully virtual law firm of about 60 attorneys located across the United States. Ray has been practicing tax law since 2002, working at some of the largest New York firms and doing a stint at Morgan Stanley. His background is specifically in financial products and financial institutions taxation, and he joined Practus in summer 2023. On this episode of Behind the Ticker, Ray breaks down the 351 exchange, a tax-efficient mechanism for converting separately managed accounts, hedge funds, and other investment vehicles into ETFs without triggering capital gains taxes.

What a 351 Exchange Actually Is

A 351 exchange, named after Section 351 of the Internal Revenue Code, allows investors to contribute appreciated securities into a newly formed ETF without triggering a taxable event. It's the same legal mechanism that has existed for decades in corporate formations and other contexts. What's relatively new is its application to ETFs. Ray explains that the basic structure involves investors transferring their portfolios of securities into an ETF in exchange for ETF shares. Because it's treated as a contribution to a corporation in exchange for stock, it qualifies as a non-recognition event for tax purposes.

The practical application is powerful. Imagine an advisor running an SMA with $50 million in appreciated stocks. If they want to move that portfolio into an ETF, selling those positions would generate a massive capital gains tax bill. A 351 exchange allows the transition without that tax hit. The investors receive ETF shares with a carryover basis (the original cost basis transfers to the new shares), so the tax isn't eliminated permanently, but it's deferred. And once inside the ETF wrapper, the portfolio can take advantage of the ETF's structural tax efficiency going forward, which is where the real compounding benefit kicks in.

Who Should Be Looking at This

Ray identifies several ideal candidates for 351 exchanges. The clearest case is an SMA manager with concentrated, highly appreciated positions who wants to move into the ETF structure. It also works well for hedge fund managers looking to convert their strategies to a more accessible format, or for family offices that have accumulated large portfolios of individual stocks over decades and want the liquidity and tax efficiency of the ETF wrapper.

One critical rule: the securities contributed must be consistent with the ETF's investment strategy. You can't dump a random collection of stocks into a focused sector ETF. The contributed portfolio needs to align with what the fund is supposed to hold. There are also requirements around diversification and the number of contributing investors, though Ray notes that the rules are more flexible than many people assume. Practus brings deep expertise in 40-Act companies (mutual funds, ETFs, closed-end funds, interval funds) combined with Ray's specialized tax background to manage these technical requirements.

Why ETF Tax Efficiency Is Driving Industry Growth

Ray explains the structural advantage that's driving explosive ETF growth. The key mechanism is the ability to rebalance portfolios without triggering taxable events through the creation/redemption process. If you hold an SMA and want to sell IBM and buy Apple, you realize the gain on IBM and owe roughly 20% in taxes. That means only $80 of your $100 value gets redeployed. In an ETF, the same rebalancing can generally be accomplished through in-kind creation/redemption without generating a taxable event for shareholders. You're moving $100 of value from one security to another without the tax haircut. Over years of compounding, this structural advantage becomes enormous.

Ray notes that some legislators, particularly Senator Wyden, have questioned whether this tax treatment should continue. There's been discussion about potentially changing the rules around Section 852(b)(6), which is the specific provision enabling tax-free in-kind redemptions. While no changes have been enacted, it's worth monitoring for anyone building long-term plans around ETF tax efficiency. Ray sees 351 exchanges becoming increasingly common as more asset managers and advisors recognize the benefits of moving existing strategies into the ETF wrapper while the current tax rules remain favorable.

Key Takeaways

• A 351 exchange allows investors to contribute appreciated securities into a new ETF without triggering capital gains taxes. The tax is deferred with carryover basis, then the ETF's structural efficiency takes over.
• Ideal candidates include SMA managers with concentrated appreciated positions, hedge fund managers converting to ETF format, and family offices with decades of embedded gains.
• Contributed securities must align with the ETF's stated investment strategy. Diversification and investor requirements exist but are more flexible than most people assume.
• ETFs can rebalance through the creation/redemption mechanism without triggering taxable events, moving $100 of value between securities without the 20% tax haircut that SMAs face.
• Ray has practiced tax law since 2002 at major NY firms and Morgan Stanley. Practus is a virtual firm of about 60 attorneys with deep ETF and 40-Act expertise.

Listen to the full conversation on Spotify, Apple Podcasts, or YouTube.