Treasury and IRS Move to Shut Down the ETF 'Tax Loophole' That Let the Wealthy Defer $6.5 Billion in Capital Gains

What Happened

On September 28, the Treasury Department and the IRS issued Notice 2026-62 along with a companion revenue ruling, taking direct aim at a tax-avoidance strategy that wealthy investors and their advisors have been using with growing frequency since 2021: the so-called Section 351 ETF conversion. Treasury Secretary Scott Bessent put the message bluntly, saying the new guidance "makes clear Treasury is serious about cracking down on transactions designed to dodge taxes or exploit our federal tax code," and adding of these particular conversions, "they don't work under existing law."

The scale of what regulators are targeting is substantial. A Bloomberg News analysis of SEC filings found that at least 105 ETFs had been created through 351 conversions, together holding roughly $22.1 billion in assets at launch and helping defer at least $6.5 billion in embedded capital gains. Morningstar's own count, using a narrower definition, still found 39 such ETFs holding $8.7 billion in seed assets contributed by individual investors between 2021 and 2025. Either way, the dollar figures show this had grown from a niche workaround into a mainstream Wall Street practice, with wealth managers increasingly pitching it as a standard portfolio-rebalancing tool for clients sitting on large, concentrated stock positions.

A related but separate notice landed the same week on crypto ETFs. BlackRock's iShares Bitcoin Trust (IBIT) and iShares Ethereum Trust (ETHA) had distributed a combined $7.22 billion in digital assets through in-kind redemptions during the first half of 2026 alone - $5.49 billion in bitcoin and $1.72 billion in ether. Treasury's notice flagged concern that some regulated investment companies were using those in-kind redemptions to keep crypto-related gains out of the income test that preserves a fund's favorable tax status, though both IBIT and ETHA are structured as grantor trusts, which already pass gains and losses directly through to shareholders rather than facing that specific test.

How the Loophole Worked, and Why Regulators Finally Moved

The mechanics of a 351 conversion trace back to a provision of the tax code that is nearly a century old. Section 351 allows an investor to contribute appreciated property - in this case, a concentrated stock position with large unrealized gains - into a corporation in exchange for shares of that corporation, without recognizing a taxable gain at the moment of the exchange. Applied to ETFs, the mechanism works like this: a wealth manager pools a client's low-basis, appreciated stock into a newly formed ETF, the client receives shares of the new ETF in return, and under Section 351's nonrecognition rule, no capital gains tax is triggered on the swap. Soon afterward, the fund can sell off the original concentrated position and buy a diversified basket instead, all without the client paying a dime of tax on the embedded gain at that moment. Technically, this is only a deferral - tax is still owed whenever the ETF shares themselves are eventually sold - but under current estate-tax law, heirs who inherit the shares get a "stepped-up" cost basis, meaning the original deferred gain can simply vanish if the investor holds until death rather than selling during their lifetime.

What makes this different from an everyday, legitimate ETF launch is the prearranged intent. Treasury's new guidance specifically targets situations where a fund is used as a conduit: the ETF holds the contributed securities only briefly before distributing or selling them, leaving the investor with what regulators call a "materially different" portfolio while the sequence was effectively planned out in advance to synthetically avoid recognizing gain. Ordinary investors who buy and sell ETF shares on an exchange were never the target - the concern is narrowly about structured, advisor-arranged conversions designed around a specific client's low-basis stock.

The timing of this crackdown lines up with a broader federal push to close revenue gaps. The notice and ruling request public comments by October 28, and Treasury has signaled that further guidance could follow - potentially reaching other techniques regulators view as similarly abusive, and possibly applied retroactively to transactions already completed. That retroactivity threat is itself notable: it tells wealth managers who have been marketing this strategy that structuring a new 351 conversion today carries real legal risk, not just a future compliance headache.

What to Take Away From This

• Tax-advantaged structures with fast-growing adoption eventually draw regulatory scrutiny. The jump from a handful of 351-conversion ETFs to over a hundred in a few years was itself a signal that eventually invites a response - a pattern worth watching in other popular investing strategies that look "too efficient."
• A deferral is not the same as an exemption. Even in its intended form, a 351 conversion only pushes the tax bill into the future; the stepped-up basis at death is what actually erases it, which is a separate and much older feature of estate tax law, not something unique to ETFs.
• Crypto ETF structure matters for how gains are taxed. IBIT and ETHA's grantor-trust structure already passes gains through directly to shareholders, which is a meaningfully different tax treatment than a traditional mutual-fund-style ETF - a detail that matters for anyone comparing crypto ETFs to equity ETFs.
• Regulatory notices with a comment period are not the final word. The October 28 deadline for public input means the rules here could still be refined before they're locked in, and investors or advisors with existing 351-conversion positions should expect more clarity - and possibly retroactive consequences - in the months ahead.

FAQ

Does this affect ordinary ETF investors who just buy and sell shares on an exchange?

No. The crackdown targets a narrow set of structured transactions arranged in advance between wealth managers and clients holding concentrated, low-basis stock. Buying or selling shares of an existing ETF on the open market isn't a Section 351 conversion and isn't affected by this guidance.

Is the Section 351 ETF strategy now illegal?

Not exactly - Treasury's position is that certain prearranged conversions never actually satisfied the law's requirements in the first place, rather than that a previously legal strategy has now been banned outright. The notice draws a clearer line around which conversions cross into the kind of transaction the IRS will challenge, and it requests further public comment before any final rule is set.

Sources

This article is an original synthesis and analysis based on the reporting below, not a reproduction of the original articles. Please check the source articles directly for the most current figures.

• Treasury Sec. Bessent, IRS crack down on ETF strategy the wealthy are using to avoid capital gains taxes - CNBC
• The Latest Tax Dodge for the Ultra-Rich Is a Customized ETF - Bloomberg
• IRS escalates crypto ETF tax scrutiny after $7.22 billion in-kind redemptions - Cryptonomist

⚠️ This article is for informational purposes only and is not investment advice. Market conditions change constantly - always verify the latest data before making investment decisions.