Exchange-Traded Funds (ETFs)

ETF tax treatment is often very confusing, but we can help.

ETFs are all the rage in the financial markets. Large institutions create them for profit, portfolio managers use them for “risk on” and “risk off” trades, and retail traders and investors are attracted to their low cost and ease of use when trading. Many different structures are used, and tax treatment can be very confusing to some — but not us. Instead of shorting stocks or an ETF, traders can buy an inverse ETF.

Securities ETFs

Securities ETFs usually are regulated investment companies (RICs). Like mutual fund RICs, securities ETFs pass through their underlying ordinary and qualifying dividends to investors. Selling a securities ETF is deemed a sale of a security, calling for short- and long-term capital gains tax treatment using the realization method.

Commodities/futures ETFs

Regulators do not permit commodities/futures ETFs to use the RIC structure, so usually they are structured as publicly traded partnerships (PTPs). Commodities/futures ETFs issue annual Schedule K-1s passing through their underlying Section 1256 tax treatment to investors, as well as other taxable items. Selling a commodities ETF is deemed a sale of a security and calls for short- and long-term capital gains tax treatment using the realization method.

Taxpayers invested in commodities/futures ETFs may need to make some cost-basis adjustments on Form 8949 to capital gains and losses, ensuring they don’t double count some of the Schedule K-1 pass-through items. For example, if the K-1 passes through income, that income will need to be added to the cost basis on Form 8949. Otherwise, it will be double counted and thus will cause an overstatement of tax liability. Form 1099-Bs and trade accounting solutions do not automatically make these cost-basis adjustments from K-1 income/loss, so be sure to make the adjustments manually on Form 8949.

Physically backed precious metals ETFs

These ETFs may not use the RIC structure either. Although they could use the PTP structure, they usually choose the publicly traded trust (PTT) structure (also known as a grantor trust). A PTT issues an annual Schedule K-1, passing through tax treatment to the investor, which in this case is the “collectibles” rate on sales of physically backed precious metals (such as gold bullion). Selling a precious metal ETF is deemed a sale of a precious metal, which is a collectible. If collectibles are held over one year (long-term), sales are taxed at the “collectibles” tax rate — the taxpayer’s ordinary rate capped at 28%. That rate is higher than the top long-term capital gains rate of 20% (2018 and 2019). Short-term capital gains are taxed at the ordinary rate. Precious metals and ETFs backed by precious metals are not securities, so they are not subject to wash-sale loss adjustments, or Section 475 ordinary gain or loss treatment.

Options on ETFs

The IRS hasn’t clearly stated tax treatment on sales of options based on ETFs. Our position is that options on securities ETFs that are organized as RICs are treated as securities, and options on commodities ETFs structured as PTPs are Section 1256 contracts. Options on precious metals ETFs (i.e., GLD) are likely Section 1256 contracts because they are non-equity options trading on a CFTC-qualified board of exchange.

Excerpt from Green’s 2019 Trader Tax Guide