On September 28, 2026, the Treasury Department and IRS released Notice 2026-62 and Revenue Ruling 2026-20, signaling increased scrutiny of ETF structures and investment strategies that they believe produce tax outcomes inconsistent with the intent of current law. Tax-free ETF seeding transactions were addressed, as were “tax-aware” investment strategies and funds designed to convert ordinary income into capital gains, generate ordinary losses, defer income recognition or generate favorable timing mismatches.
Treasury appears increasingly willing to challenge transactions that technically comply with the Internal Revenue Code (IRC) but produce tax results that are inconsistent with the purpose of the provisions. While tax advisors have always focused on using the Code to optimize tax outcomes, tax strategy is now commonly embedded into and marketed directly to investors as a primary reason to invest in a product or fund.
ETF Seeding Transactions
In Revenue Ruling 2026-20, the IRS addressed certain Section 351 ETF seeding transactions that let investors contribute appreciated securities to a newly formed ETF and change the portfolio’s composition without recognizing a gain. The IRS concluded that certain ETF seeding transactions involving a prearranged plan to exchange appreciated securities for exposure to a materially different portfolio should be recharacterized as taxable exchanges under Section 1001.
Key Tax-Aware Strategies Identified by Treasury
No-Dividend ETFs
Treasury identified specific ETF structures that involve parent ETFs holding lower-tier ETFs and distributing those holdings prior to a dividend record date and replacing them with another ETF tracking the same index. In essence, current dividend income goes unrecognized while the fund maintains the same economic exposure.
Section 988 / Section 1256 Character Conversion Strategies
Treasury highlighted identified straddle strategies that pair:
- Section 988 foreign currency forwards (ordinary treatment), and
- Section 1256 futures contracts (60% long-Term/40% short-Term capital treatment).
The Notice specifically focuses on identified straddles under Section 1092(a)(2) that may generate capital gains while preserving ordinary losses. Treasury believes this outcome may be inconsistent with the intent of the straddle rules under Section 1092.
Same-Day Section 988 Elections
The Notice specifically identifies strategies where taxpayers wait until trading results are known before electing capital treatment (under Section 988(a)(1)(B)) only for profitable Section 988 transactions while allowing loss transactions to retain ordinary character. Treasury views this use of hindsight as an area of concern.
Swap Termination Strategies
Treasury also identified strategies involving notional principal contracts (swaps) where appreciated positions are terminated immediately before payment dates to generate capital gain treatment, while loss positions are held to maturity to generate ordinary losses. The difference in treatment is being determined by timing rather than by economic exposure.
Practical Takeaways for Fund Managers, Investors and Tax Advisors
- Review prior ETF seedings, exchange fund transactions and investments in tax-aware products.
- When performing due diligence on a fund, fund manager or strategy, review and inquire about the use of Section 988 elections, Section 1256 contracts, identified straddles, swaps and dividend minimization structures.
- Expect increased scrutiny of products marketed primarily on tax efficiency or tax alpha that specifically use the strategies discussed.
- Carefully evaluate any strategy that consistently produces capital gains alongside ordinary losses or converts ordinary income into deferred capital gains. While a strategy may be structured in such a way that does not run afoul of the Code, it is important to understand the potential exposure should the IRS and Treasury choose to enforce this retroactively or proactively in the future.
- Documentation of non-tax investment objectives may be useful to substantiate positions taken.
- Consider whether any open tax years involve strategies discussed.
- Monitor for additional rules; Treasury noted that further guidance may be forthcoming.
- Note that this article does not discuss certain ETF strategies identified in Notice 2026-62, including box spread and other RIC-focused arrangements involving §852(b)(6). Taxpayers with investments in RICs should consider whether such strategies may be identified by the Notice.
The Bottom Line
Treasury and the IRS requested comments on the transactions described in the Notice. Guidance may be issued in the future, which could apply either prospectively or retroactively at the time of issuance. Treasury and the IRS also indicated that the IRS may challenge these transactions under existing law prior to additional guidance. This makes proper diligence essential now rather than waiting for further guidance and commentary.
The message from Treasury and the IRS is clear: conventional tax planning and use of the instruments mentioned in and of themselves are still viable, but strategies that rely on highly technical character, selective election-based strategies and timing are under scrutiny for potentially running afoul of current tax law and congressional intent. This appears to signal a renewed willingness to challenge strategies that Treasury and the IRS believe are inconsistent with the purpose of existing tax rules.
Questions on how the latest Treasury and IRS guidance may affect your fund, investment strategies or tax position? Contact a Grassi advisor to discuss what these developments may mean for you.
