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Tax Considerations When Dealing With ETFs

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Exchange Traded Funds (ETFs) are an investment vehicle that has been available since the early 1990s but has become more popular after the market crash in 2008.
The EFTs were introduced into the market to enable investors who wanted to have passive investments in stocks and commodity markets to invest their funds.
Unlike traditional funds that held stocks, bonds, and commodities in a portfolio that depended on decisions made by the fund managers, an ETFs portfolio is managed in a passive way (in that the stocks held are from an investment category).
For example, from a given price index such as the Dow Jones or a given industry such as stocks in the oil sector.
Therefore, the performance of the index or category replicates the performance of the fund.
In this case, the investor decides on the ETF in which to invest his or her funds.
One can invest in the Dow Jones ETF, gold EFT, biotechnology companies ETFs, and such other categories.
These funds will therefore, hold an equal proportion of the various stocks or commodities that are contained in a given index or category, so as to replicate the index or category performance.
Varieties of ETFs The Exchange Traded Funds or Exchange Traded Products are of different types.
The exchange-traded notes deals with alternative investment categories while the master limited partnerships deal with commodities such as diamonds, oil, currency, and gold.
Investors Shift to ETFs Though ETFs have been in the market for quite some time - since early 1990s - the demand for these investment options have been on the rise in the recent past.
Since 2009, investors have shifted funds of over $75 billion from mutual funds to EFTs.
Many of these investors are seeking to diversify to commodity and currency investments that are more shielded from economy performances as was experienced in the 2008 market crash.
So far, these ETF investments have performed fairly well and thus, encouraging more investors to flood towards them.
Tax Implications and Considerations However, one of the major pitfalls of the EFTs is that they are a complex product when it comes to taxation and many investors have found themselves in a tax crisis when preparing taxes.
Some ETF funds will require the taxpayer to file taxes in different states, depending on the structure of the ETFs and others will require profits to be taxed at different rates.
Therefore, before getting into an ETF investment, you will need to scrutinize the structure and the tax implications of the funds.
The tips below may assist you in this process:
  • Structure of the ETFs - Most ETFs are run as corporations, partnerships, or trusts.
    The limitations that arise from these structures are that losses and profits are forwarded to the individual investors and the investors are therefore, taxed on the investment incomes directly.
    At times, the direct taxation can get complex.
    For example, in the case of ETF partnerships investing in futures, investors of these ETFs may be expected to pay income tax on profits made and not realized, and therefore, pay taxes without receipt of any distributions.

  • Precious Metals - ETF investments that are structured as trusts and that invest in precious metals are taxed at a higher rate of 28% as opposed to the 15% capital gain tax rate because the metals are deemed as collectibles.
    Some of the ETFs that have these metals in their portfolios include SPDR Gold Trust, Sprott Physical Silver Trust, and iShares Silver Trust.

  • Cost Basis - Mutual fund managers and stockbrokers are now required by law - starting 2012 - to track cost price of the investments for the calculation of capital gains.
    However, for ETFs that are structured as partnerships or grantor trusts, the cost basis is not required by law and therefore, the investor must keep proper records to track costs prices for purpose of calculating taxable capital gains.
    Furthermore, stockbrokers and mutual funds companies are required to send out a form 1099 that is used in preparing taxes related to the investment.
    This requirement is not mandatory for ETF partnerships.

  • State Taxes - If the ETF is run as a publicly traded partnership, incomes generated from a given state require a corresponding tax return made to the state.
    In this case, an investor may end up having to file tax returns to many states that he or she does not live in.
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