If you hold an outsized and highly appreciated position that you would like to diversify out of, then this post is for you. Many people find themselves in this situation, whether you acquired it by working at a successful company for many years, buying early, or receiving the holding as a gift.

In this post, we assess several options available, with a focus on the 351 exchange as a tax-efficient and low-cost way to diversify.

Tools for diversification

Some solutions are simple and effective, while others are complex, high-cost, and aren’t worth the tax savings.

The easiest way to diversify a large, appreciated position, especially if you are adding savings to your portfolio, is to be patient and buy diversifying assets with new money.  This has no tax consequences but isn’t always an available solution.

There are three other options for managing the risk of this position:

1. Sell the holding, pay taxes. One could choose to slowly sell their concentrated holding when they deem optimal.

2. Hedge the ups and downs of the position with put and call options.  One could buy/sell options contracts to lock in the current value of this holding.

3. Use an Exchange Fund. An exchange fund is a product where one can put their appreciated stock into a communal pool of assets with other investors.

The table below outlines the pros and cons of each one:

None of the strategies above are ideal if your goals are to diversify and save on taxes.  A 351 exchange, which we discuss below, has some operational complexity, but is otherwise low-cost and effective.

Enter the 351 exchange

A 351 exchange is similar to an exchange fund in that you transfer your appreciated holdings into another fund, receiving shares of a diversified portfolio that typically tracks a known index in return with the same cost basis as that of the holdings transferred in.

The diagram below illustrates the transfer:

The 351 exchange, however, differs in several key ways:

1. You must contribute a portfolio of stocks, not just a single one.

2. It offers liquidity because you receive shares in an ETF that is traded daily.

3. It can rebalance out of your concentrated holding and into a diversified index without passing taxes on gains to shareholders through its ETF structure.

4. Fees also tend to be significantly lower than for an exchange fund.

In summary

This new ETF has now become a potential long-term holding offering flexibility. You could hold it until you pass away, receiving a step up in cost basis and thus avoiding taxes on the gains entirely. Alternatively, you could occasionally sell a portion when your tax rate is lower, without having to worry about the performance of one individual company. Because the resulting holding is liquid, you retain complete control over how and when you manage the investment.

For these reasons, we believe a 351 exchange is a valuable tool to consider when seeking to diversify a concentrated and highly appreciated holding.

DISCLOSURES:  The information contained herein is the property of Greenline Partners, LLC and is circulated for information and educational purposes only. There is no consideration given for the specific investment needs, objectives or tolerances of any of the recipients. Additionally, Greenline's actual investment positions may, and often will, vary from its conclusions discussed herein based upon any number of factors, such as client investment restrictions, portfolio rebalancing and transaction costs, among others. Reasonable people may disagree about a variety of factors discussed in this document, including, but not limited to, key macroeconomic factors, the types of investments expected to perform well during periods in which certain key economic factors are dominant, risk factors and various assumptions used. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This report is not an offer to sell or the solicitation of an offer to buy the securities or instruments mentioned. No part of this document or its subject matter may be reproduced, disseminated, or disclosed without the prior written approval of Greenline Partners, LLC.