How ETFs And ETNs Are Taxed

April 15th is right around the corner and many of us are biting are nails trying to figure out just exactly how our exchange traded notes (ETNs) and exchange traded funds (ETFs) will be taxed.

It is actually fairly simple.  For those of us who own ETNs, they are only taxed upon sale of the fund under normal capital gains rates.  Paul Justice of Morningstar takes it a step further and outlines these helpful basic ETN tax rules (these go for ETNs other than for currency tracking funds):

• They generally holds no real assets, they are actually promissory notes
• You are taxed only upon sale
• Short-term capital gains rates are applied if held for less than one year
• Long-term capital gains rates are applied if held for more than one year
• They typically do not generate interest or dividend income

As for ETFs, they could be a little trickier.  Commodities 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 (USO) is formed as a partnership interest, so if you own the ETF, you are a limited partner and will receive a K-1.

The good news is that if these ETFs are held in a tax-deferred account, like an IRA, because they are passively managed, you will not be subject to the Unrelated Business Taxable Income clause and get nailed with a tax liability.

To take it a step further, if you owned a limited partnership interest in an ETF that owns only futures contracts, such as USO or PowerShares DB Agriculture (DBA), you will be taxed each year.  The IRS allows you to use the 60/40 rule where you can treat 60% capital gains as long-term and 40% as short-term.  Additionally, the fund doesn’t distribute realized capital gains and there is no UBTI to report.  However, you will have to report interest income.  Now if this held in an IRA, you won’t have to pay tax on the interest until you withdraw your money, and the 60/40 rule doesn’t apply.

Another form that ETFs take is that of a grantor trust.  Examples of these include SPDR Gold Shares (GLD) and iShares Silver Trust (SLV).  These funds hold physical metals and are therefore taxed at ordinary income rates upon sale.  On the positive side, they don’t generate realized capital gains or interest income.

Last are the tax implications of 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 funds will be taxed at short-term rates and you will pay taxes annually on the funds, regardless if you sell or hold on to them.  On occasion, these funds make large taxable distributions after periods of gains.

The Internal Revenue Code can be pretty tricky and complicated, and for this reason we suggest that you consult with your tax advisor before filing your 1040, as we are not accountants and this should not be construed as tax advice.

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