7958 / What are the tax advantages of owning 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 an ETF is sold, 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, a taxpayer must hold an ETF for more than one year to receive long-term capital gains treatment. If the security is held for one year or less, then it will receive short-term capital gains treatment.

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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.

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As with stock, taxpayers are subject to the wash-sale rules if an ETF is sold for a loss and then repurchased within 30 days. A wash sale occurs when a taxpayer sells or trades a security at a loss and, within 30 days after the sale, the taxpayer:

• Buys a substantially identical ETF;


• Acquires a substantially identical ETF in a fully taxable trade; or


• Acquires a contract or option to buy a substantially identical ETF.

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Planning Point: If a loss was disallowed because of the wash-sale rules, the taxpayer should add the disallowed loss to the cost of the new ETF. This increases the basis in the new ETF. This adjustment postpones the loss deduction until the disposition of the new ETF. The holding period for the new ETF begins on the same day as the holding period of the ETF that was sold.

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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, a taxpayer can assume that any dividend received on common or preferred stock is an ordinary dividend unless the paying corporation specifies 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 specify whether the dividends that have been paid are ordinary or qualified.