Among the investment products advisors recommend to their clients, mutual funds and exchange-traded funds top the list. ETFs in particular are a popular product for thier tax-favored status — but how precisely are they taxed? What are the exceptions to the general rules? And what about dividends from mutual funds or real estate investment trusts? If you’re looking for detailed answers to these and other questions, read on.
1. What are the tax advantages of owning exchange-traded funds (ETFs)?
One of the advantages of owning ETFs is their tax efficiency.
ETFs enjoy a more favorable tax treatment than mutual funds due to their unique structure. Mutual funds create and redeem shares with in-kind transactions that are not considered sales. As a result, they do not create taxable events. However, when you sell an ETF, the trade triggers a taxable event. Whether it is a long-term or short-term capital gain or loss depends on how long the ETF was held. In the United States, to receive long-term capital gains treatment you must hold an ETF for more than one year. If you hold the security for one year or less, then it will receive short-term capital gains treatment.
Planning Point: Long-term capital gains are normally taxed at a favorable rate of 20 percent, 15 percent or 0 percent, depending on the taxpayer’s income tax bracket. These favorable rates were made permanent for tax years beginning after 2012.
As with stocks, you are subject to the wash-sale rules if you sell an ETF for a loss and then buy it back within 30 days. A wash sale occurs when you sell or trade a security at a loss and within 30 days after the sale you:
•Buy a substantially identical ETF,
•Acquire a substantially identical ETF in a fully taxable trade, or
•Acquire a contract or option to buy a substantially identical ETF
Planning Point: If your loss was disallowed because of the wash-sale rules, you should add the disallowed loss to the cost of the new ETF. This increases your basis in the new ETF. This adjustment postpones the loss deduction until the disposition of the new ETF. Your holding period for the new ETF begins on the same day as the holding period of the ETF that was sold.
Many ETFs generate dividends from the stocks they hold. Ordinary (taxable) dividends are the most common type of distribution from a corporation. According to the IRS, you can assume that any dividend you receive on common or preferred stock is an ordinary dividend unless the paying corporation tells you otherwise. These dividends are taxed when paid by the ETF as ordinary income.
Qualified dividends are subject to the same maximum tax rate that applies to net capital gains. In order to qualify:
1.An American company or a qualifying foreign company must have paid the dividend.
2.The dividends must not be listed with the IRS as dividends that do not qualify.
3. The required dividend holding period must be met.
The ETF provider should tell you whether the dividends that have been paid are ordinary or qualified.
2. How are ETFs taxed?
ETF shares represent undivided interests in the assets held by the fund. ETFs are “organized either as open-end investment companies or unit investment trusts.” ETFs organized as unit investment trusts generally qualify for tax treatment as regulated investment companies for tax purposes.
Exchange-Traded Funds Invested in Metals. In a memorandum prepared by the Office of Chief Counsel of the IRS, which was made public only as the result of a court order, the IRS advised that the sale of an interest in an ETF that directly invests in metal (“physically-backed metal ETF”) is treated as the sale of a “collectible,” such that any gain from the sale of the interest is subject to the maximum capital gain rate of 28 percent (i.e., instead of the 20%/15%/0% capital gain rate). The Service reasoned that in the case of a physically-backed metal ETF that is treated as a trust, the investor is treated as owning an undivided beneficial interest in the collectible held by the trust. Accordingly, if the investor sells an interest in the ETF or the trust sells a portion of the collectible, the investor is treated as having sold all or a portion of his or her share of the collectible held by the trust, and any gain from the sale of the trust interest or sale of the collectible by the trust is treated as collectible gain and, therefore, is subject to the maximum capital gain rate of 28 percent. However, if a physically-backed metal ETF is not structured as a trust, or if the ETF does not directly invest in the metal, then the above rule does not apply. The Service cautions that the structure of each physically backed metal ETF should be considered to determine the tax consequences of an investment in that ETF.
3. What are the exceptions to the general rules for how ETFs are taxed?
As in just about everything, there are exceptions to the general tax rules for ETFs. A good way to think about these exceptions is to know the tax rules for the sector. ETFs that fit into certain sectors follow the tax rules for the sector rather than the general tax rules. Currencies, futures, and metals are the sectors that receive special tax treatment.
Most currency ETFs are in the form of grantor trusts. This means the profit from the trust creates a tax liability for the ETF shareholder, which is taxed as ordinary income. They do not receive any special treatment, such as long-term capital gains, even if you hold the ETF for several years. Since currency ETFs trade in currency pairs, the taxing authorities assume that these trades take place over short periods.
These funds trade commodities, stocks, Treasury bonds, and currencies. For example, PowerShares DB Agriculture (AMEX:DBA) invests in futures contracts of the agricultural commodities — corn, wheat, soybeans, and sugar — not the underlying commodities. Gains and losses on the futures within the ETF are treated for tax purposes as 60 percent long-term and 40 percent short-term regardless of how long the contracts were held by the ETF. Further, ETFs that trade futures follow mark-to-market rules at year-end. This means that unrealized gains at the end of the year are taxed as though they were sold.
If you trade or invest in gold, silver, or platinum bullion, the IRS considers it a “collectible” for tax purposes. The same applies to ETFs that trade or hold gold, silver, or platinum. As a collectible, if your gain is short-term, then it is taxed as ordinary income. If your gain is earned for more than one year, then you are taxed at either of three capital gains rates, depending on your tax bracket. This means that you cannot take advantage of normal capital gains tax rates on investments in ETFs that invest in gold, silver, or platinum. Your ETF provider will inform you what is considered short-term and what is considered long-term gains or losses.
4. How are dividends received from a mutual fund taxed?
Mutual funds may pay three kinds of dividends to their shareholders; generally, taxable dividends will be reported to the shareholder on Form 1099-DIV.
(1) Ordinary income dividends. Ordinary income dividends are derived from the mutual fund’s net investment income (i.e., interest and dividends on its holdings) and short-term capital gains. A shareholder generally includes ordinary income dividends in income for the year in which they are received by reporting them as “dividend income” on his or her income tax return.
However, under JGTRRA 2003, qualified dividend income is treated in some respects like net capital gain and is, therefore, eligible for what are now the 20%/15%/0% tax rates instead of the higher ordinary income tax rates. (ATRA 2012 made the special treatment of “qualified dividends” permanent — or as permanent as anything in the IRC.) As a result of JGTRRA 2003, mutual funds are required to report on Form 1099-DIV the nature of the ordinary dividend being distributed to shareholders — that is, whether the ordinary dividend is a “qualified dividend” subject to the 20%/15%/0% rates (Box 1b), or a nonqualifying dividend subject to ordinary income tax rates (Box 1a). Unless otherwise designated by the mutual fund, all distributions to shareholders are to be treated as ordinary income dividends.
Ordinary income dividends paid by mutual funds are eligible for the 20%/15%/0% rate if the income being passed from the fund to shareholders is qualified dividend income in the hands of the fund andnot short-term capital gains or interest from bonds (both of which continue to be taxed at ordinary income tax rates).
The Service has stated that mutual funds that pass through dividend income to their shareholders must meet the holding period test for the dividend-paying stocks that they pay out to be reported as qualified dividends on Form 1099-DIV. Investors must also meet the holding period test relative to the shares they hold directly, from which they received the qualified dividends that were reported to them. In summary, the holding period test must be satisfied by both the mutual fund and the shareholder in order for the dividend to be eligible for the 20%/15%/0% rate.
The Service has ruled that in making dividend designations (under IRC Sections 852(b)(3)(C), 852(b)(5)(A), 854(b)(1), 854(b)(2), 871(k)(1)(C), and 871(k)(2)(C)), a mutual fund may designate the maximum amount permitted under each provision even if the aggregate of all the amounts so designated exceeds the total amount of the mutual fund’s dividend distributions. (IRC Section 852(b)(3) provides rules for determining the amount distributed by a mutual fund to its shareholders that may be treated by the shareholders as a capital gain dividend (see below). IRC Section 854 provides rules for determining the amount distributed that may be treated as qualified dividend income. IRC Section 871(k) provides rules for determining the amount distributed that may be treated as interest-related dividends or short-term capital gain dividends.) The Service further ruled that individual U.S. shareholders may apply designations to the dividends they receive from the mutual fund that differ from designations applied by shareholders who are nonresident alien individuals.
Varying distributions paid by a mutual fund to shareholders in different “qualified groups” (shares in the same portfolio of securities that have different arrangements for shareholder services or the distribution of shares, or based on investment performance) constitute deductible dividends for the mutual fund.
An award of points to a shareholder under an airline awards program, in which one point is awarded for each new dollar invested in the mutual fund, will not result in the payment of a preferential dividend by the fund; instead, the investor will be informed of the fair market value of the points and informed that the basis in the shares giving rise to the award of points should be adjusted downward by the fair market value of the points as a purchase price adjustment.
Certain pass-through entities are required to report as part of a shareholder’s ordinary income dividends the shareholder’s allocated share of certain investment expenses (i.e., those which would be classified as miscellaneous itemized deductions if incurred by an individual), in addition to ordinary income dividends actually paid to a shareholder. The shareholder then must include such additional amount in income and treat the amount as a miscellaneous itemized deduction (subject to the 2 percent floor) in the same year. However, publicly offered regulated investment companies (generally mutual funds) are excluded from the application of this provision.
(2) Exempt interest dividends. Some mutual funds invest in securities that pay interest exempt from federal income tax. This interest may be passed through to the fund’s shareholders, retaining its tax-exempt status, provided at least 50 percent of the fund’s assets consist of such tax-exempt securities. Thus, a shareholder does not include exempt-interest dividends in income. The mutual fund will send written notice to its shareholders advising them of the amount of any exempt-interest dividends. Any person required to file a tax return must report the amount of tax-exempt interest received or accrued during the taxable year on that return. Under JGTRRA 2003, exempt-interest dividends do not count as qualified dividend income for purposes of the 20%/15%/0% tax rates.
(3) Capital gain dividends. Capital gain dividends result from sales by the mutual fund of stocks and securities that result in long-term capital gains. The mutual fund will notify shareholders in writing of the amount of any capital gain dividend. The shareholder reports a capital gain dividend on the federal income tax return for the year in which it is received as a long-term capital gain regardless of how long the shareholder has owned shares in the mutual fund. As such, a capital gain dividend may be partially or totally offset by the shareholder’s capital losses (if any); if not totally offset by capital losses, the excess (i.e., net capital gain) will be taxed at the applicable capital gains rate. For additional guidance on designations of capital gain dividends, see Rev. Rul. 2005-31, above.
The Service issued guidance clarifying that capital gain dividends received from a mutual fund in 2004 would be taxed at the lower capital gain rates enacted under JGTRRA 2003. Concern had been expressed that the prior rules for dividend designation and the transition to the new, lower capital gain rates might cause some 2004 capital gain dividends to be taxed to mutual fund shareholders at the old, higher rates. However, the guidance clarified that this would not occur.
Generally, a shareholder may elect to treat all or a portion of net capital gain (i.e., the excess of long-term capital gain over short-term capital loss) as investment income. If the election is made, the amount of any gain so included is taxed as investment income. This election may be advantageous if the shareholder’s investment interest expense would otherwise exceed his investment income for the year. If the shareholder makes the election, the shareholder must also reduce net capital gain by the amount treated as investment income.
Detailed instructions for reporting mutual fund distributions on Form 1040 or Form 1040A are set forth in Publication 564, Mutual Fund Distributions (2011).