NCPA - National Center for Policy Analysis

Exchange Traded Funds Cause Tax Headache for Investors

June 30, 2011

Even though exchange traded funds (ETFs) trade like stocks and provide diversification like a fund, they often are structured very differently from the stocks and mutual funds many investors grew up with.  Mutual funds generally aren't allowed to hold commodities directly, so the firms offering ETFs have turned to less familiar vehicles, such as partnerships, trusts or corporations, says the Wall Street Journal.

There is a big difference at tax time: While, for example, holders of gold stocks in a mutual fund would pay tax on long-term capital gains (those held longer than a year) of 15 percent, long-term gains for Gold Shares (the largest commodity exchange traded fund) holders are taxed at 28 percent because physical gold is a "collectible."  Tax advisers and preparers are worried:

  • "Most investors in these products have no grasp of what they're getting into," says Robert Gordon, head of Twenty-First Securities Corp. in New York.
  • Confused investors probably won't find much individual help from sponsors on thorny issues like having to file returns in multiple states or the fine points of mark-to-market rules for funds holding futures.

That is why paying your tax preparer to sort it out can cost so much.  Here is just one example: Many ETFs are organized as partnerships for regulatory reasons, and they issue an annual K-1 tax report to each investor.  A K-1 is like the 1099 for your mutual fund, but much longer and far more complex.  CPAs say each K-1 from an ETF takes up to an hour to put into a tax return, often at rates north of $150 an hour.

For investors in commodity ETFs, tax surprises can dent or even erase the gains they thought they got.  With these new products, the old adage "know what you own" may not be enough.  You also need to know what you'll owe, says the Journal.

Source: Laura Saunders and Jason Zweig, "Extreme Tax Frustration," Wall Street Journal, June 25, 2011.

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