The “Tax-Free Forever” ETF Redemption Loophole Is Safe. Treasury Just Drew a Line Around Six Ways Funds Have Been Stretching It
The IRS just put six ETF tax strategies on notice while leaving the core redemption rule untouched, and the difference between what survives and what draws an audit comes down to one word in the tax code.
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The IRS left the core redemption rule alone. It named six other strategies, cited six Code sections, and said it will fight them under laws already on the books.
Your Index ETF Keeps Its Tax Shield Under Notice 2026-62
The IRS issued Notice 2026-62 on September 28, 2026. Financial Times, the WSJ and Bloomberg called it a Treasury crackdown on Wall Street tax-avoidance strategies.
The notice leaves ordinary ETF creations and redemptions alone. Internal Revenue Code Section 852(b)(6) stays in place. The IRS now says it will challenge funds that use that machinery as part of a “coordinated plan” to dodge tax.
How Section 852(b)(6) Makes Capital Gains Disappear
Section 311(b) normally taxes a corporation that distributes appreciated property as if it had sold it. Section 852(b)(6) turns that rule off. It applies when a regulated investment company (RIC), the tax category for ETFs and mutual funds, distributes property to pay for a redemption.
A fund buys 10,000 shares for $200,000 and they’re now worth $1 million. If it sold them, it would realize an $800,000 gain and pass it to shareholders as taxable income. Instead, it gives the shares to an authorized participant. That participant is a large trading firm that creates and redeems ETF shares in big blocks, and the fund takes back ETF shares. The fund realizes no gain.
The gain isn’t taxed when the shares go out, and the fund doesn’t lower the basis of what it holds. The untaxed gain gets absorbed or transferred to continuing shareholders without tax consequence at the transaction level.
For you, that means deferral. You owe tax on your own gain when you sell your ETF shares. Hold them until death. The step-up in basis can eliminate that gain out, which is where the “tax-free forever” nickname comes from. This is why Invesco QQQ (NASDAQ:QQQ) could hold roughly $490 billion in net assets as of June 30, 2026 while rarely paying out capital gains. The iShares Core S&P 500 ETF (NYSEARCA:IVV) prospectus lists three transaction methods: in-kind, partial cash and all cash.
Six Strategies the IRS Says It Will Now Challenge
The notice names six strategies.
- Section 351 conversions that pair transfers of appreciated stock with redemptions right after.
- Partnership exchange fund variations under Section 721 that get around diversification requirements.
- Box spread funds that avoid the tax on options gains.
- Record date strategies that make dividend income disappear.
- RIC income test avoidance, done by handing out assets that don’t count as qualifying income.
- Tax-aware character conversion, which uses straddles (Section 1092), foreign currency contracts (Section 988) and terminations of notional principal contracts (Section 1234A).
Before and After: What a 351 Conversion Was Worth
Before this notice, the IRS had not formally challenged routine ETF creation and redemption practices. Take an investor holding a $500,000 portfolio with a $100,000 basis. At 2026’s top federal rate of 20% plus the 3.8% net investment income tax, he’d owe about $95,200. He uses a 351 conversion. He puts the stock into a new ETF tax-free, keeps his $100,000 basis, and lets the fund’s redemptions remove out the low-basis shares.
Now the IRS says it will challenge these deals. It will do so under existing Code provisions, regulations and judicial doctrines when they produce results that Sections 351, 721, 852(b)(6), 988, 1092 and 1234A were never designed to allow. A routine ETF redemption remains routine. A 351 conversion may be technically legal but is now officially under scrutiny.
Three Tax Moves You Can Still Use
- Hold broad index ETFs in taxable accounts. The 852(b)(6) shield applies, and the Vanguard S&P 500 ETF (NYSEARCA:VOO) costs 0.0003 of assets a year.
- Read Form 8937 before believing “tax-free” income. For the fiscal year ending May 31, 2025, the NEOS Nasdaq-100 High Income ETF (NASDAQ:QQQI) classified between 94.453385% and 98.856172% of each distribution as return of capital under Section 301(c)(2). That money isn’t taxed now but lowers your basis, so you pay later when you sell.
- Keep your most appreciated ETF shares for heirs. The step-up in basis still delivers the “forever” part.
Watch for public comment deadlines or proposed regulations. Work out whether a conversion or planned sale makes sense with a CPA.
Data Sources
- Notice 2026-62: issue date, the six strategies, the Code sections cited, and how the gain goes unrecognized.
- Notice 2026-62: how the IRS treated ETF redemptions before the notice and how it says it will apply now.
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Vilma Rios is a tax professional and tax content contributor with more than 15 years of experience in tax and accounting. She specializes in federal tax research, tax education, and translating complex tax rules into clear, practical information for individuals, families, and small-business owners.
Vilma is a Content Tax Contributor II with the National Association of Tax Professionals (NATP), where she contributes to tax education and professional content. She has also presented tax information through webinars, including Spanish-language tax education, and has appeared on Telemundo 47 discussing tax topics and helping viewers understand important tax-filing requirements.
Her experience also includes tax and accounting work, tax research, IRS-related matters, and public tax education. While in college, Vilma volunteered in an IRS-sponsored tax assistance program and was recognized for her community service by local and state officials.
Known as “Your Tax Geek,” Vilma is passionate about making taxes easier to understand and helping people navigate an increasingly complex tax system.
