More of the uber rich are turning to this ‘slam dunk’ method of avoiding taxes that’s perfectly legal

There are strong ethical arguments both for and against capital gains taxes, which leaders have toyed with increasing in recent years as the animosity toward the wealthy balloons.

For one, the levy is a dependable way for debt-laden governments to collect revenue, and at the same time, serves to target those who have the most capital — the bemoaned 1%. But, many argue that such taxation stifles investment, and with it, erodes the productivity and economic growth that investment spawns. And, it can lead to a “lock-in effect” on assets, dampening market efficiency and fluidity as people hold onto stocks and property for longer than they would otherwise.

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Whether you think it’s fair, profits from selling real estate and other investments are subject to duties ranging from 0% to 37%, depending on how long the asset was held and your taxable income. Those who have the most to lose from the tax, though, have found ways around it, one of the most popular being a little-known, completely legal ETF trick that experts call a “slam dunk” — and anyone can use it.

The now-famous 351 conversion

Along with strategies like “buy, borrow, die” and tax loss harvesting, there is something known as a 351 conversion that allows investors to defer and/or reduce capital gains fees.

Through the move, one can fold individual stocks into an exchange-traded fund in which they then own shares. Assets can be bought and sold freely via in-kind creation and redemption within the fund, bypassing the taxes you would have to pay if you’d simply sold off individual shares that had appreciated to, say, buy into an ETF instead.

By changing your investment, your tax bill doesn’t just disappear; it gets deferred to the date you sell those ETF shares, and the amount still depends on the difference between the money you originally invested and the money you take out. Still, withdrawing that money at a later time when you’re in a lower income bracket could mean you pay less, while giving you more control to balance your holdings in the meantime (as opposed to holding individual stocks) without the tax drag.

This type of conversion is primarily used as a way to rebalance and diversify — especially in cases where a winning asset grows to comprise more of your portfolio than you’d like — without triggering capital gains procedures. It’s named after the section of the tax code that permits it, which states “no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control.”

Some firms now advertise vehicles to facilitate such a conversion for smaller investors, though The Daily Upside notes that many “were not designed with the sole purpose of attracting investors to the tax-friendly exchange.” Nonetheless, it’s been popular enough to catch the eye of the US Treasury Department this year, which is now considering deeming 351s as potentially tax-avoidant, thus requiring more IRS involvement.

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The fine print

Of course, certain criteria must be met in the case of a 351. For one, the reason for starting the fund must not be simply to dump winning securities tax-free. And, as far as concentration is concerned, no security can make up more than 25% of your existing portfolio, no five securities can surpass 50% and there must be at least 11 different holdings in the new fund.

Also, as stated in the code, the investor(s) must own at least 80% of the ETF as soon as it is launched.

While ETFs are known for having fewer “taxable events” than other investment products and are extremely common for that and other reasons, the process of a 351 conversion can be quite complicated and contain its own set of risks. Ultimately the move should be thoroughly discussed with a financial advisor and other professionals before it is even considered.

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This article originally appeared on Moneywise.com under the title: More of the uber rich are turning to this ‘slam dunk’ method of avoiding taxes that’s perfectly legal

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