A Retiree Sells Her $500,000 Portfolio for a $45,000 Bill. A ‘Section 351’ Swap Promised Zero, Until the IRS Said No.
A legal workaround let investors swap appreciated stock into an ETF without triggering capital gains taxes, and thousands of retirees used it. Now the IRS has a ruling that reframes the entire transaction, and the tax bill could arrive retroactively.
This post may contain links from our sponsors and affiliates, and Flywheel Publishing may receive compensation for actions taken through them.
If you own a few index ETFs in a brokerage account, a new IRS notice includes a sentence written with you in mind. On September 28, 2026, the Treasury Department and the IRS released Notice 2026-62. It goes after a small group of engineered deals that ride on the same machinery that makes ETFs tax-efficient.
Short answer: the notice says it leaves alone the routine share creation and redemption that keeps ETF capital gains distributions low. The exposure belongs to investors who moved appreciated stock into an ETF through planned transactions that the agencies describe as “novel investment fund strategies”.
Why Your ETF Rarely Sends You a Capital Gains Bill
ETFs trade with big Wall Street firms called authorized participants. These firms “transact directly with the ETF to acquire large blocks of ETF shares (creation units)” and hand those blocks back when they want out. When a block comes back, the notice explains, “the ETF determines the specific assets that it distributes in redemption. Often, the ETF distributes appreciated securities.”
That transfer is called an in-kind distribution: the fund pays in stock, not cash. When it follows Section 852(b)(6) of the tax code, it results in “nonrecognition of realized gain or loss for the ETF.” So the fund clears out its most appreciated shares without selling them, and you never get a gain to report.
The notice states simply that “ETFs regularly engage in such creation and redemption transactions,” and that, “except to the extent discussed below, this notice does not address such distributions.”
Section 351 Conversion Deals Are the Real Target
Section 351 lets you transfer property to a corporation in exchange for its stock without paying tax on the gain. For tax purposes, an ETF counts as a corporation. Here’s how the notice describes the setup: an investor contributes a diversified, appreciated portfolio to an ETF. The ETF then issues creation units to an authorized participant for securities or cash that fit its strategy. Next, it redeems those units by handing the investor’s original securities to the participant.
In the notice’s words, investors “expect to avoid recognition of the built-in gains in their securities” while ending up in “an ETF with a materially different portfolio of securities.” The agencies conclude the two provisions “are being combined as part of a plan to achieve a result that neither provision was designed to produce.”
A second version targets investors holding just one or two big positions. They pool their stock in a partnership that puts “at least 20 percent” of its assets into things other than stocks or securities. The partnership then carries out the same conversion.
What a $300,000 Deferred Gain Is Worth
Imagine a retiree with a diversified stock portfolio worth $500,000 that cost $200,000. If she sells to change strategies, she realizes a $300,000 long-term gain. Taxed at the 15% federal capital gains rate, that comes to $45,000.
If her income puts the whole gain in the 20% bracket and also sets off the 3.8% net investment income tax, the bill grows to $71,400. Most states with an income tax add their own share. A conversion promised her the same switch with no tax now. That deferral is exactly what the IRS is challenging.
Rev. Rul. 2026-20 Treats the Swap as a Sale
The companion ruling, Rev. Rul. 2026-20, says these contributions are “properly characterized as taxable exchanges under § 1001 by the contributing investors with the authorized participant rather than a contribution to the ETF that qualifies as a §351 transaction.” Put simply, the investor is treated as having traded her stock to the authorized participant, and the gain is taxed.
The notice states no view on using Section 351 to seed a new ETF with assets “intended and expected to be retained by the ETF.”
Retroactive Guidance Risk Falls on Deal Participants
More rules may follow, possibly including calling these deals a “transaction of interest or a listed transaction.” That guidance “could apply prospectively only or retroactively to transactions that already have taken place.” The IRS can also challenge these strategies in an audit under current law.
The agencies also promise that any guidance “will target specific abusive transactions, will minimize compliance burdens, and will respect market expectations with respect to conventional, long-established tax planning that is consistent with the intent of Congress.”
Here’s how that separates readers:
- Likely exposed: Investors who put appreciated holdings into an ETF, or into an exchange-fund partnership, as part of a planned conversion.
- Likely unaffected: Investors who bought ETF shares with cash on an exchange. The notice proposes no change to how those shareholders are taxed, and it sets routine redemptions outside its scope.
- Still unknown: The scope, timing and form of the final rules, whether they will reach back to past deals, and what, if anything, happens to other shareholders in funds that took in converted portfolios.
If you did a conversion, pull the transaction documents and find out whether your ETF shares took a carryover basis. That’s the number that determines what you could owe if the IRS applies the ruling’s logic to you, and it’s worth checking with a CPA or fiduciary tax advisor before final guidance comes out. This is one of a growing list of IRS rules that can quietly drain a portfolio, and we covered the others in a free guide to retiree tax traps.
Contact [email protected] for any questions or corrections.
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.
