Tax Rates Differ For ETF Asset Classes

BY TRANG HO

INVESTOR'S BUSINESS DAILY

Posted 12/15/2008

Depending on whether they hold stocks, metals and futures, as with inverse and leveraged ETFs, ETF asset classes are taxed differently.

Some are taxed as ordinary income, some as capital gains and some as collectibles, with tax rates ranging from 15% to 35%.

So it behooves tax-sensitive investors to be aware of how gains in various asset classes are treated by the tax man.

Robert Green, CEO of GreenTraderTax.com and author of "The Tax Guide for Traders" and the forthcoming "Green's 2009 Trader Tax Guide," says investors can apply the rules to their advantage.

IBD: How are different asset classes among ETFs taxed?

Green: ETFs based on securities are taxed like securities. Short-term capital gains are taxed up to the ordinary income tax rate, which rises to the highest level of 35%. And long-term capital gains are taxed up to 15%. So if you hold an ETF security for over 12 months, you'll get the lower 15% rate. If you sell it before 12 months, it's short term, and you pay up to the highest rate of 35%.

ETFs based on precious metals like gold or silver, such as SPDR Gold Trust (GLD), are subject to the collectibles tax rate, which is currently as high as 28% on a long-term capital gain and 35% on a short-term capital gain.

If you trade an ETF based on a future other than precious metals, you will get 60-40. And 60-40 means whether you hold it for a day or over a year, you pay a blended rate for short-term and long-term capital gains: 60% is long-term, taxed up to 15%; 40% is short-term, taxed up to 35%.

Due to the math, the highest blended rate is 23%, which is 12% less than the short-term rate on securities of 35%.

What about options on ETFs? The IRS has not issued tax guidance for that, so it's not clear. An industry practice is to treat options on ETFs as futures for the more beneficial, lower 60-40 tax rate. Usually you don't hold an option for over a year, so you're not looking for the long-term rate.

IBD: Some ETFs hold stocks overseas. Does that subject you to the tax structure of the host country?

Green: No. Generally, when you buy and sell securities, financial instruments, it's not considered income in the country in which you're trading.

So if nonresident aliens open a brokerage account and trade U.S. stocks, they're not taxed on capital gains as a nonresident alien, unless they're here for more than 183 days.

When an American trades in a foreign country or with a foreign broker or buys foreign instruments from a U.S. broker, there is no foreign tax.

If your foreign account has more than $10,000, you need to file a TDF 90-22.1, a foreign bank account reporting form. The Treasury is really busting taxpayers big time with severe penalties if they don't file those forms.

IBD: What can investors do at year-end to control tax consequences?

Green: There's a lot of specialized tax planning. Those who trade as a business have special challenges for year-end planning. They may want to have wash sales (sales that lock in losses, followed by buys within one month to regain exposure; typically not allowed by the IRS for tax purposes) if they've already exceeded the capital-loss limitation, and they may also want to have unrealized losses rather than realize them. Why? Because the unrealized losses and the wash losses can be turned into ordinary business losses in the following year.

If you're not a business trader this year, but you're going to be a business trader next year, you may want to save some of your year-end purchases of equipment (for) next year or startup expenses. If you are a business trader this year, then you want to load up on them because you just get more business deductions.

For example, if a trader does not rise to the level of trader tax status or didn't use Section 475 in '08, they're stuck with capital-loss treatment and they may have a capital loss which is well beyond the $3,000 capital-loss limitation.

It would be a mistake for them to generate more capital losses with tax-loss selling because they couldn't get the benefit; they're already into the capital-loss carryover situation.

And wash sales, which are generally considered bad by the mainstream financial media, can actually be helpful to the business trader because they can reduce capital-loss carryovers and instead get wash-sale-loss carryover. And the wash-sale-loss carryover can be turned into an ordinary loss in the subsequent year with a Section 475 mark-to-market accounting election. So the trader does the reverse of what they generally hear.

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