An Alternative To Taxes?

May 24, 2007

These ETNs just get more interesting all the time. Commodities, India, currency, buywrite … BGI just picks off one inaccessible or tax-inefficient part of the market after another. You have to wonder what’s next.

VIX? Hedge Fund indexes? Gold bullion? Principal protection? Leverage?

I’m sure other people out there have some ideas…

If these ETNs keep their favorable tax treatment – and that remains a big IF – they will be a tax-sensitive investor’s best friend. Zero distributions, all dividend income deferred … the only taxable event happens when you sell. And if you’ve held for more than a year, it’s all long-term capital gains, taxed at just 15%.

Tax issues are becoming increasingly important as investors move into alternative assets, which don’t enjoy the same favorable treatment as regular stocks and bonds.

My sense is that some people have been caught off-guard by the tax implications of their investments. Here is my cheat sheet:

Futures-Based Commodity ETFs (DBC, GSG, USO, DBA, DBB, etc.): There is no deferral of gains with these ETFs. Period. All futures investments are “marked-to-market” at the end of the year. That means if you buy the US Oil Fund (USO) for $50/share and it closes on December 31 at $60/share, you owe taxes on that $10/share gain … even if you never sold the ETF. That’s right: you have to come up with the cash out-of-pocket. These gains are taxed 60% as long-term gains and 40% as short-term gains.

Bullion-Based Commodities (GLD, IAU, etc.): Long-term capital gains on these ETFs are taxed at 28%, not 15% like stocks. The reason? The IRS considers these “collectibles.” If you buy the streetTRACKS Gold ETF (GLD) for $50/share and sell it for $60/share two years later, you pay 28% tax on that gain … not 15%.

Currencies (FXE, FXA, etc.): All gains from these ETFs are taxed as regular income. All of them. If you buy the CurrencyShares Euro Trust (FXE) for $50/share and then sell it for $60/share two years later, you pay income tax rates on that $10 spread, not capital gains. So instead of paying 15%, you pay whatever your top tax rate is (up to 35%).

Leverage (ProShares): These funds use short-term swaps to provide leveraged returns. The swaps generate large amounts of short-term capital gains. Last year, the ProShares Ultra QQQ (QLD) paid out $5.42 in short-term gains on an $89/fund. That’s substantial.

BuyWrite: There are no buywrite ETFs, but there are lots of buywrite closed-end funds. These funds all pay out distributions on a monthly or quarterly basis—yields that add up to about 10% per year. These distributions are taxed 60% as long-term gains and 40% as short-term gains.

Of course, the structure of the ETNs does bring certain risks. These are debt instruments, after all. If Barclays goes bankrupt, ETN shareholders can join the line of folks looking for ten cents on the dollar.

Is that likely? Of course not. But anything’s possible. You have to think shareholders would have enough warning to exit positions, but you can never be 100% sure.

Find your next ETF

Reset All