A highly appreciated stock position can be a good problem to have. But when one investment becomes a large percentage of a portfolio, it can also create meaningful risk.
The obvious solution—sell the stock and diversify—may create a substantial capital-gains tax bill. That does not necessarily mean an investor should continue holding an oversized position. It means the tax consequences should be considered alongside the investment risk.
There is rarely one perfect solution. In many cases, the best approach combines several strategies.
Start With the Simplest Option: Sell Gradually
Diversification does not have to happen all at once.
An investor might sell a portion of an appreciated position each year, spreading realized gains across multiple tax years. The amount sold can be coordinated with other income, deductions, charitable gifts, realized investment losses, and expected changes in tax rates.
This approach does not eliminate the tax liability, but it can make the transition more manageable while steadily reducing concentration risk.
The trade-off is straightforward: the investor remains exposed to the concentrated stock while the strategy is being implemented.
Use Investment Losses Strategically
Tax-loss harvesting can help offset gains realized while reducing a concentrated position.
If other investments are trading below their cost basis, selling those investments may generate capital losses that can offset capital gains. The proceeds can then be reinvested in an appropriate replacement investment while observing applicable tax rules.
Tax-loss harvesting should not drive the portfolio, but when losses are available, they can create an opportunity to diversify appreciated holdings more tax-efficiently.
Give Appreciated Stock Instead of Cash
For investors who are already charitably inclined, gifting appreciated securities can be particularly useful.
Rather than selling stock, paying capital-gains tax and donating the remaining cash, an investor may be able to contribute appreciated shares directly to a charity or donor-advised fund.
Subject to applicable tax rules, this can:
- Remove the appreciated stock from the portfolio
- Avoid realizing the embedded capital gain on the donated shares
- Potentially generate a charitable deduction
- Allow the investor to use other assets to rebalance the portfolio
This strategy works best when the charitable gift was something the investor already intended to make.
Exchange Funds
An exchange fund allows investors to contribute appreciated securities to a partnership in exchange for an interest in a more diversified pool of investments.
Instead of selling the original stock immediately, the investor receives an interest in the fund and generally continues to defer the embedded gain.
Exchange funds can be useful for investors with very large concentrated positions, but there are important trade-offs. They may require substantial minimum investments, involve long holding periods—many are structured around a seven-year period—and include fees, illiquidity, manager risk and exposure to investments the investor might not otherwise choose.
The IRS’s September 2026 guidance discusses a particular partnership strategy that combines a partnership with a subsequent §351 ETF conversion. Importantly, the IRS specifically stated that the notice does not address other transactions involving exchange funds and expresses no view regarding those other transactions.
Section 351 ETF Contributions
Another strategy that has received considerable attention is contributing appreciated securities to a newly created exchange-traded fund in a transaction intended to qualify for tax-deferred treatment under Section 351 of the Internal Revenue Code.
When properly structured, Section 351 can allow property to be contributed to a corporation in exchange for its shares without immediately recognizing gain. However, multiple requirements apply, including rules involving control, diversification and transfers to investment companies. A Section 351 transaction should therefore not be viewed simply as a way to exchange any appreciated stock for a diversified ETF without paying tax.
New IRS Guidance
In September 2026, the IRS and Treasury issued Revenue Ruling 2026-20 and Notice 2026-62, specifically addressing certain Section 351 ETF transactions.
The ruling targets transactions in which an investor contributes appreciated securities to a newly formed ETF and, as part of the same plan, some or all of those contributed securities are shortly thereafter transferred out of the ETF through a redemption with an authorized participant. The ETF ultimately owns a materially different portfolio, while the investor has effectively exchanged the original appreciated securities for the new ETF without recognizing the embedded gain.
The IRS concluded that, under those facts, the ETF can effectively be treated as a conduit and the investor can be treated as having completed a taxable exchange under Section 1001, rather than a qualifying Section 351 contribution.
That distinction is important.
The guidance does not say that every Section 351 ETF contribution is taxable. Notice 2026-62 specifically states that it does not address transactions used to seed a newly established ETF when the contributed assets are consistent with the ETF’s investment thesis and are intended and expected to remain in the ETF absent a substantial change in circumstances.
The IRS has also indicated that it is considering additional guidance concerning Section 351 conversion transactions.
For investors considering this strategy, the structure of the transaction matters enormously. Investors should understand what securities are being contributed, whether those securities fit the ETF’s investment strategy, what is expected to happen to them after the contribution, and how tax counsel has evaluated the transaction.
Sometimes the Best Strategy Is a Combination
These techniques do not have to be mutually exclusive.
An investor might:
- Donate some appreciated shares to charity
- Realize available investment losses
- Sell part of the position over several tax years
- Evaluate an exchange fund for another portion
- Consider a Section 351 transaction where the facts and structure support it
- Retain a smaller position in the original company
The objective should not necessarily be to eliminate every dollar of capital-gains tax. Avoiding taxes at the expense of taking excessive investment risk can be an expensive trade.
The better question is: How can the portfolio become appropriately diversified while managing the tax consequences as intelligently as possible?
For investors with substantial embedded gains, answering that question often requires coordinating investment management, tax planning, charitable planning and estate planning rather than treating the stock position in isolation.
Disclosures
This material is provided for informational and educational purposes only and should not be construed as individualized investment, tax, accounting, or legal advice, or as a recommendation to implement any particular strategy or transaction.
The strategies discussed involve risks, limitations, eligibility requirements, and tax consequences that vary based on an investor’s individual circumstances. Tax laws, regulations, administrative guidance, and their interpretation may change, and the tax treatment of any transaction cannot be guaranteed.
Section 351 transactions and exchange funds involve complex tax and investment considerations. Whether a particular transaction qualifies for tax-deferred treatment depends on its specific facts and structure. Recent IRS guidance has addressed certain Section 351 transactions involving ETFs, and additional guidance or interpretations may be issued.
Investors should consult with their tax and legal advisors regarding their individual circumstances before implementing any tax-related investment strategy. Bishop Capital Advisors does not provide tax or legal advice.