Moving Your Portfolio into an ETF Still Works. Trading It for a New One Doesn't.

Key Takeaway:

Moving a diversified portfolio into a new ETF under Section 351 still works. Using the ETF to trade into a different portfolio is a taxable exchange in the IRS's view, and that applies to exchanges that have already been done. If you contributed in 2025 and your return is on extension, talk to your preparer before October 15.

On September 28, 2026, Treasury and the IRS put out two pieces of guidance on Section 351 ETF exchanges, the strategy that lets you move an appreciated stock portfolio into a brand-new ETF without paying tax on the way in. If you've read the coverage, you might think the strategy is dead. It isn't. What the IRS went after is narrower: using the ETF to trade your old portfolio for a different one and calling it tax-free.

These strategies have been heavily marketed by specific ETF providers, and the Composition Wealth tax and investment teams have struck a collective tone that these exchanges were at risk of coming under IRS scrutiny. As such, we have avoided recommending them to clients.  We wish it could be easy to adjust  your current portfolio without a tax consequence, but it’s just not that easy. Whether a particular deal lands on the wrong side comes down to what was planned when the investor went in.

How a 351 exchange works

If you move property into a corporation and the people moving property in together own at least 80% of it afterward, you haven't sold anything, so there's no tax. It's the same rule that lets a founder put a business into a new corporation without a tax bill. Exchange Traded Funds (ETFs) are corporations for tax purposes, which is why a new one can take in appreciated stock this way. These events are known as 351 exchanges and there have been an increasing number of ETFs seeded and launched with contributed stock over the last few years using this section of the tax code. 

Congress built in a limit for investors: the portfolio has to be diversified already. No single holding can be more than 25% of the value, and the five biggest together can't top 50%. Fifteen technology stocks could pass, which tells you the test is about tax rather than whether the portfolio is well built.

What you get back is ETF shares, which carry the same cost basis as the shares of stock you contributed. A coat check is a decent picture of it, with one difference: your ticket isn't for your own coat but for a slice of everything on the rack. You hand over your stocks, you get a ticket, nothing is taxed, and the gain sits there until you cash the ticket in.

The other moving part is how ETFs handle redemptions. Big trading firms, called authorized participants, can bring securities to the fund for new shares, or turn shares in and leave with securities. When one of them leaves with appreciated stock, Section 852(b)(6) says the fund owes no tax on that gain. It's why ETFs seldom distribute capital gains.

Used plainly, that combination is useful. You defer the gain instead of paying tax just to change wrappers, which on a large account keeps real money invested. Several investors can go in together, each with a diversified account, and end up sharing the combined portfolio, which the regulations allow. After launch, the fund can rebalance for years without passing much gain through to shareholders. You still owe the tax eventually, when you sell, so deferral is the whole benefit, and it's worth having.

Where the IRS drew the line

The recent guidance from the IRS is aimed at a more aggressive version of the 351 exchange. Say your $5 million account carries $3 million of built-in gain, much of it in a few tech names, and you'd rather own a global index. Selling would trigger the gain. So instead, you contribute your stocks to a new ETF built to hold a global index. An authorized participant brings in global-index stocks for shares and, a few days later, as planned all along, turns those shares back in and leaves with your technology positions. The fund now holds the global index, and so do you, through your shares. On paper nobody paid tax, because your contribution was tax-free, the fund's redemption was tax-free, and the authorized participant bought and sold at the same price.

Rev. Rul. 2026-20 sees a trade. You gave the authorized participant your stocks and got a global index back. The ruling treats the ETF as "merely a conduit" and taxes you as if you'd made that exchange directly, but only on the securities the authorized participant took. 

The IRS didn't need new law to get there. The ruling relies on substance over form and the step-transaction doctrine, Supreme Court cases going back to the 1930s, and a 1971 ruling on a similar contribute-then-redeem sequence between shareholders. That's also why it has no effective date. A revenue ruling isn't a statute or a court decision; it's how the IRS interprets current law, so it applies to every tax year still open. 

In fairness, Congress did write both rules, the authorized participant is an unrelated party, and the fund (not the investor) picks which securities go out. That's a real argument. We'd still rather not be the ones testing it in court. Even Practus, a law firm that has handled numerous 351 ETF launches, wrote after the guidance that it has "long advised clients that Treasury and the IRS may invoke judicial doctrines" when a 351 transfer is part of a coordinated plan to rebalance a portfolio without recognizing gain.

What still works

Go back to the coat check. If you contribute an account of large U.S. companies to a new large-cap ETF that wants to own those same companies, nobody needs to walk out with them. They stay, and over time the fund trims and adds as markets move. The same goes for an advisor who has run a diversified strategy in separate accounts for years and moves it into an ETF with the same holdings and the same manager. In both cases the vehicle changes and the investments don't. Notice 2026-62 sets that case aside: an ETF seeded with assets that fit its strategy and that the fund intends and expects to keep "absent a substantial change in circumstances." The notice doesn't approve these either; it "expresses no view." And neither the ruling nor the notice sets a holding period or retention percentage, so what matters is whether the exit was planned going in.

The rest of the notice

The recent IRS Notice 2026-62 doesn’t just address 351 exchanges, although they are a significant component of it. They also address: 

vehicles using options contracts as a means of both swapping interest income for capital gain treatment as well as deferring the recognition of it (known as box spreads), 

ETF strategies designed to avoid the realization of dividend income, and

private investment vehicles that use complex derivative contracts to generate ordinary losses alongside capital gains. 

None of these is banned yet, but the IRS says it may challenge them on audit now, and future rules could apply retroactively.

If you've already done a 351 exchange

If yours lands on the wrong side of the ruling, the cost is mostly timing: tax on the positions the authorized participant took, paid earlier rather than twice, plus interest. And don't sell the ETF until the deal has been reviewed; a sale can add a second taxable event without fixing the first.

While we have not recommended 351 exchanges to our clients, if you have done one, we are here to help. Bring the offering documents to your advisor and we'll go through them with you and your tax preparer. If your 2025 return is still on extension, we'll want to see them before October 15.

Sources

1. Rev. Rul. 2026-20 (Sept. 28, 2026), Facts, Law and Analysis, Holding (amplifying Rev. Rul. 71-336, 1971-2 C.B. 299). irs.gov/pub/irs-drop/rr-26-20.pdf

2. Notice 2026-62 (Sept. 28, 2026), §§ 1, 2.01–2.06, 3.01–3.04, 4.02. irs.gov/pub/irs-drop/n-26-62.pdf

3. I.R.C. §§ 351(a), (e)(1); 368(a)(2)(F)(ii), (c); 358(a)(1); 852(b)(6); Treas. Reg. § 1.351-1(c)(1), (5), (6)(i).

4. Minnesota Tea Co. v. Helvering, 302 U.S. 609 (1938); Commissioner v. Court Holding Co., 324 U.S. 331 (1945).

5. R. Elwood and R. Holst, "No Big Chill for Section 351 Transfers After New IRS Guidance," Practus LLP, Sept. 30, 2026.

Disclosures

Composition Wealth, LLC (“Composition Wealth”) is a registered investment adviser. Advisory services are offered only to clients or prospective clients where Composition Wealth and its representatives are properly licensed or exempt from licensure. This communication is for informational purposes only and should not be considered investment, financial, tax, or legal advice. Please consult your own tax, legal and accounting advisors before making any related decisions.