Unique Tax Characteristics of Exchange Traded Funds

Exchange Traded Funds (ETFs) represent a bundle of assets that look a lot like a mutual fund, only they may be traded during the day just like ordinary stocks (mutual fund units may only be redeemed at the end of the day). ETFs have gained a reputation as a low cost, tax efficient alternative to mutual funds. The only problem with this perception is that it may not be accurate. ETFs that invest in currencies or commodities can create bizarre tax ramifications to which the capital gains tax rate rules simply do not apply. This article will address the tax implications of investing in three forms of ETFs: Plain Vanilla (bundles of company stocks), Currency and Commodity ETFs.

Plain Vanilla ETF
A Plain Vanilla ETF gives the investor a tiny piece of various companies that are held in the fund. Like an Index Mutual Fund a Plain Vanilla ETF is a type of investment company which invests its funds in stocks that mirror some particular market index, such as the S&P 500 or the NASDAQ 100. Plain Vanilla ETFs can be grouped into four basic categories: Broad-Based ETFs, Fixed Income ETFs, International ETFs and Sector ETFs. Broad-Based ETFs follow specific indexes styles such as growth indexes, value indexes, small-cap, mid-cap and large- cap indexes. Fixed Income ETFs track indexes for corporate and Treasury bonds. International ETFs track indexes for foreign countries as well as international regions (i.e. Asia). Sector ETFs track indexes for specific industries such as health care.

Currency ETF
Currency ETFs aren't funds at all but, rather, trusts or limited partnerships that pass income and gains through to their investors. Accordingly, each owner of a Currency ETF takes into account his or her pro rata share of the ETF's income, gain, loss, deductions and other items for the calendar year. If you are an investor in a Currency ETF you will receive a K-1 for the year. This K-1 will itemize each specific type of income and expense passed through to you, the investor. The tax treatment of such income or gains depends on the Fund's underlying positions, so you must read the prospectus to understand the tax treatment of such income, expense, gain or loss. Currency ETFs allow you to capitalize on the strength of foreign currencies relative to the U.S. dollar. Whenever a U.S. investor buys a currency ETF, they are automatically short the dollar in the corresponding currency. This type of strategy allows you to hedge against weakness in the dollar. Currency ETFs can be taxed in eight different ways. Currency ETFs can be taxed as long-term capital gains, short-term capital gains, ordinary income, interest income, part capital gains/part ordinary income, phantom interest (interest not received) and phantom ordinary income (mark to market gains for futures contracts). Currency ETFs can create bizarre tax treatment that even your CPU would not understand.

Commodity ETFs
Like Currency ETFs, Commodity ETFs are not funds but, rather, trusts of limited partnerships that pass income and gains through to their investors. Accordingly, each owner of a Commodity ETF takes into account his or her pro rata share of the ETF's income, gain, loss, deductions and other items for the calendar year. If you are an investor in a Currency ETF you will receive a K-1 for the year. This K-1 will itemize each specific type of income and expense passed through to you, the investor. The tax treatment of such income or gains depends on the Fund's underlying positions, so you must read the prospectus to understand the tax treatment of such income, expense, gain or loss. Commodities are tangible assets used to manufacture and produce goods or services. Specific examples of basic commodity categories include agriculture, energy, livestock, metals, timber and textiles. In the agriculture segment, familiar commodities include cotton, coffee, and wheat. In the energy area, examples of commodities include natural gas and crude oil. In a Commodity ETF you are investing in a basket of commodities, which is good as it provides diversification for your commodity investment portfolio. For commodity ETFs that utilize futures contracts 60% of any gains are taxed at the long-term capital gains rate while the remaining 40% of gains are taxed as short term, which are subject to the investor's ordinary income tax rate. A commodity ETF may be subject to phantom income on mark to market gains required to be recognized by the fund. If the ETF actually holds a basket of precious metals for more than a year, such gains are subject to a 28% capital gains tax rate.

What I want you to take away from this article is to tread lightly when investing in Currency or Commodity ETFs. You must thoroughly understand what type of income the ETF investment will generate and what your tax rate will be for the various types of income generated by the ETF. With tax rising you don't want to be surprised on April 15th by the tax effects of your ETF investment.