No one likes paying taxes, but broadly speaking, exchange-traded products are tax-efficient vehicles. Most exchange-traded funds offer tax advantages over their mutual fund rivals. However, the tax treatment of commodity ETFs is different from that of equity-based funds. And commodity exchange-traded notes, or ETNs, are taxed differently than their ETF counterparts.
As measured by assets under management, the most popular segment of the commodity ETF universe is precious metals or funds backed by holdings of gold, silver, palladium or platinum. Although these ETFs are highly popular, they come with a potentially nasty tax surprise. Investors who hold equity or bond-based ETFs for a year or more and then sell at a profit are subject to capital gains tax at a maximum rate of 15 percent. However, the IRS treats gold-backed ETFs and related products as collectibles. That means investors who hold these funds a year or longer and then sell at a profit pay a tax rate of 28 percent. Sell one of these ETFs after less than a year, and the tax rate jumps to 35 percent.
Another popular niche of commodity ETFs is energy, particularly funds that offer exposure to oil and natural gas. These ETFs differ from their gold and silver counterparts in that they are not backed by physical holdings. Therefore, the IRS has an entirely different way of taxing oil and natural gas ETFs. These ETFs are constructed as limited partnerships, meaning investors get a K-1 form every year at tax time. As if the added complexity to completing your tax return is not enough, the way these ETFs are taxed can cause headaches, too. Oil and natural gas ETFs that are sold at a profit force the investor to treat 60 percent of the profits as long-term capital gains, taxed at 15 percent. That is not so bad. What is bad is that the other 40 percent is treated as a short-term capital gain regardless of how long the ETF was held, and it's taxed at a higher rate.
Metals and Energy ETNs
Aside from knowing that ETNs are debt instruments that hold no stocks, futures contracts or metals as most ETFs do, the most important thing about ETNs for investors is how this asset class is taxed. Simply put, when it comes to commodity ETNs, investors own no underlying securities and receive no distributions or dividends. That means the only taxes for investors are on long- or short-term capital gains. That's it.
For the most part, ETN taxation is straightforward and favorable to ETFs when it comes to commodities. But ETNs that offer exposure to foreign currencies are an exception. The IRS can tax currency ETN gains as ordinary income at a rate up to 35 percent.
Todd Shriber is a financial writer who started covering financial markets in 2000. He worked for three years with Bloomberg News and specializes in analysis of stocks, sectors and exchange-traded funds. Shriber has a Bachelor of Science in broadcast journalism from Texas Christian University.