An ETF's taxation is ultimately driven by its underlying holdings. Since funds are structured differently according to how they gain exposure to the underlying asset, an exchange-traded fund's tax treatment inherently depends on both the asset class it covers and its particular structure.
Many commodity funds that hold futures contracts are regulated by the Commodity Futures Trading Commission as commodities pools, but they're classified as limited partnerships (LPs) for tax purposes by the IRS. Therefore, "LP" will be used to refer to the structure of these funds throughout this article.
Commodity ETFs come in one of three structures: grantor trusts; LPs; or ETNs. Knowing the structure of commodity funds is crucial, since the tax implications differ dramatically between the various structures.
|MAXIMUM CAP GAINS TAX RATE|
|Open End ('40 Act)||N/A||N/A|
|UIT '(40 Act)||N/A||N/A|
|Grantor Trust ('33 Act)||28%||39.60%|
|Limited Partnership ('33 Act)*||27.84%**||27.84%**|
|ETN ('33 Act)||20%||39.60%|
**Max rate of blended 60% LT/40% ST
NOTE: These rates are NOT inclusive of the 3.8 percent Medicare surcharge tax or any additional taxes applicable from the phase-out of itemized deductions and personal exemptions.
Commodity Grantor Trusts
Grantor trust structures are used for "physically held" precious metals ETFs. These and related funds store the physical commodity in question in vaults, giving investors direct exposure to spot returns.
Under current IRS rules, investments in these precious metals ETFs are considered collectibles. Collectibles never qualify for the 20 percent long-term tax rate applied to traditional equity investments; instead, long-term gains are taxed at a maximum rate of 28 percent. If shares are held for one year or less, gains are taxed as ordinary income; again, at a maximum rate of 39.6 percent.
Many ETFs hold futures contracts to gain exposure to commodities, and are structured as LPs.
Futures-based funds have unique tax implications. Currently, 60 percent of any gains are taxed at the long-term capital gains rate of 20 percent, and the remaining 40 percent is taxed at the investor's ordinary income rate, regardless of how long the shares are held. This comes out to a blended maximum capital gains rate of 27.84 percent.
LP ETFs are considered pass-through investments, so any gains made by the trust are "marked to market" at the end of each year and passed on to its investors, potentially creating a taxable event. This means your cost basis adjusts at year-end, and you can be subject to paying taxes on gains whether or not you sold your shares.
For tax reporting, LP ETFs also generate a Schedule K-1 form. This can create uncertainty and annoyance for the average investor not familiar with K-1s when they receive these forms in the mail.
Commodity Exchange-Traded Notes
Commodity ETNs do not hold the physical commodity, nor do they hold futures contracts. They are unsubordinated, unsecured debt notes issued by banks that promise to provide the return of a specific index. This means they carry credit risk: If the bank issuing the note goes bankrupt or defaults, investors can lose their entire investment.
Commodity ETNs are currently taxed like equity and/or bond funds. Long-term gains are taxed at 20 percent, while short-term gains are taxed as ordinary income (maximum 39.6 percent). Despite the fact that many of these products track futures-based indexes, they do not generate a K-1.
Choosing The Right Fund For You
From a tax perspective, the time period that you expect to own that asset can make a difference. For short-term holders in higher tax brackets, LPs offer a strong tax benefit, since 60 percent of any gains are taxed at the low 20 percent tax rate, regardless of holding period. In other structures, short-term gains are taxed as ordinary income, with rates up to 39.60 percent.
On the flip side, long-term investors might gain an advantage with ETNs because they are subject to 20 percent long-term gains, compared with the 60/40 blend of partnerships, which comes out to a blended maximum of 27.84 percent. The Catch-22 is that ETNs come with credit risk of the counterparty.
Then there are tax reporting differences. The tax structure associated with LPs can be challenging for investors who are accustomed to 1099s when they receive K-1s in the mail. For investors looking to simplify their taxes without K-1s, grantor trusts and ETNs might look more appealing.
Disclaimer: We are not professional tax advisors. This article is for informational purposes only and not intended to be tax advice. Tax rules can change. Individuals should always consult with a professional tax advisor for details about the tax implications of investment products and their personal taxes.
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