As the end of the year rapidly approaches, it is important to understand how Uncle Sam will treat one’s ETF and ETN holdings.
With the vast array of ETFs to choose from, taxes can get tricky. In general the tax treatment of ETFs is relatively simple and is applicable to long-term and short-term capital gains rules and rates. For example if one held the SPDR S&P 500 ETF (NYSE:SPY) for less than one year, any gains would be subject to short-term capital gains rates and if held for longer than one year, then the gains would be subject to long-term capital gains rates.
It gets tricky when one starts dealing with commodities ETFs. These ETFs shoot of Schedule K-1’s, which track the gains and losses of the fund for the year, because they are actually limited partnership interests in the fund. For example, United States Oil (NYSE:USO) is formed as a partnership interest, so those who own the ETF have a partnership interest in the fund and will receive a K-1 outlining gains or losses.
On the bright side, if these passively managed ETFs are held in a tax-deferred account, like an IRA, they will not be subject to the Unrelated Business Taxable Income clause increasing one’s tax liability.
Another catcher is that these ETFs which own only futures contracts and are structured as limited partnerships are taxed every year, regardless of holding periods. However, the IRS does allow the use of the 60/40 rule where 60% of all capital gains are taxed at long-term capital gains rates and 40% at short-term capital gains rates.
Another form of commodity ETFs that are taxed at an unfriendly rate are grantor trusts which hold physical metals, like the SPDR Gold Shares (NYSE:GLD) and the iShares Silver Trust (NYSE:SLV). These funds are deemed as collectibles by the IRS and taxed at 28%. On the bright side, they do not generate realized capital gains or interest income.
The last class of ETFs that are taxed in unconventional methods are leveraged ETFs. These funds hold options and swaps secured by pools of cash and generate interest income from the cash which is taxed at ordinary income rates. Additionally, capital gains from these ETFs are taxed at short-term rates, regardless of holding periods. Additionally, leveraged ETFs have been known to make large taxable distributions after periods of large gains.
When it comes to ETNs, taxes are a lot simpler. First off, ETNs are only taxed at time of sale and are subject to normal capital gains rates based on holding periods. Additionally ETNs typically do not generate interest or dividend income.
The exception to the ETN rules lies in currency ETNs. ETNs linked to a single currency are treated like debt for federal tax purposes. This means that any interest is taxable to investors, even though the interest is reinvested and not paid out until the holder sells the ETN or the contract matures. It also means that gains or losses on the sale or redemption will generally be ordinary, and investors will not be able to elect capital gain treatment.
When it comes time to pay Uncle Sam his share of the pie, it is always a good idea to consult with a tax attorney or account for clarification.
Written By Kevin Grewal From ETF Tutor Disclosure: No Positions
Kevin Grewal is the founder, editor and publisher of ETF Tutor and serves as the editor at www.SmartStops.net, where he focuses on mitigating risk and implementing exit strategies to preserve equity. Additionally, he is the editor at The ETF Institute, which is the only independent organization providing financial professionals with certification, education, and training pertaining to exchange-traded funds (ETFs). Prior to this, Grewal was a quantitative analyst at a small hedge fund where he constructed portfolios dealing with stock lending, exchange-traded funds, arbitrage mechanisms and alternative investments. He is an expert at dealing with ETFs and holds a bachelor’s degree from the University of California along with a MBA from the California State University, Fullerton. He is a contributing author on The Street – his articles can also be found published on various sites including Yahoo! Finance, The Globe and Mail , Daily Markets, MSN Money, Seeking Alpha, Fidelity Investments, Traders Library, and Minyanville.