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

Exchange-traded funds (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.

Securities ETFs are usually registered 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-term and long-term capital gains tax treatment.

Commodities/futures ETFs

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

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. Income passed through on K-1s is added to cost basis.

Precious metals ETFs

Physically backed precious metals 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, calling for short-term and long-term “collectibles rate” capital gains tax treatment. 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%. Short-term capital gains are taxed at the ordinary rate. (Read our blog “Tax Treatment for Precious Metals” which includes discussion on all sorts of precious-metal ETFs and ETNs. Mining ETFs are securities.

Options on ETFs

The IRS hasn’t clearly stated tax treatment on sales of options based on ETFs. Some tax attorneys make the case that sales of exchange-listed options on broad-based securities ETFs as well as on commodities or futures ETFs should be treated as Section 1256(g)(3) non-equity options, with lower 60/40 tax rates. Sales of options based on narrow-based securities ETFs are treated like securities. Although we tended to agree with this tax treatment in the past, starting in mid-2012 we adopted a more conservative view of ETF options. All options on securities ETFs that are organized as RICs are treated as securities.

For more in-depth information on ETF tax treatment, read Green’s Trader Tax Guide and our blog ETF tax and regulatory issues.

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