Commodity exchange traded funds surged over the last three months after a lackluster 2013. With commodity-related ETFs and exchange traded notes (ETNs) back in the limelight, it is important for investors to understand how these products operate and how the IRS taxes these investment vehicles.
Commodity ETFs and exchange traded notes have been among the best performers year-to-date, with the iPath Dow Jones-UBS Coffee Total Return Sub-Index ETN (NYSEARCA:JO) rising 81.6% so far this year on the severe drought conditions in Brazil, the world's top producer of coffee.
While it may be fun to play these types of short-term market moves in the commodities market, investors will have to deal with the slightly different taxes associated with the investments.
Commodities ETFs and other funds that use futures contracts to gain exposure to a market are structured as limited partnerships. Consequently, investors may have to fill out a Schedule K-1 instead of Form 1099, and they may incur Unrelated Business Taxable Income (UBTI), which could be taxable in an IRA. However, most ETFs provide K-1s in a timely manner and typically do not generate UBTIs.
Futures-backed ETFs, unlike equities and stock-based ETFs, are based on the so-called 60/40 rule: 60% long-term gains at a maximum 23.8% rate and a 40% short-term gains at a maximum 43.4% rate, depending on the tax bracket, regardless of how long the investor holds the ETF.
Moreover, at the end of the year, the ETF must "mark to market" all outstanding contracts and treat them as if the fund sold those contracts, and investors would realize those gains for tax purposes.
Taxation of ETNs differs from that of ETFs. ETNs are a type of bond or debt security issued by an underwriting bank and subject to the credit risk of the issuer. Gains in stock, bond and commodity ETNs are taxed at a maximum long-term 23.8% rate and maximum 43.4% rate.
Lastly, physically backed ETFs, like the SPDR Gold Shares (NYSEARCA:GLD), which gained 14.6% year-to-date, are treated as if investors held the physical bullion. Physically-backed metal ETFs are taxed as collectibles with long-term gains at a maximum 31.8% tax rate and short-term gains taxed up to a 43.4% rate.
Max Chen contributed to this article.
Disclosure: I am long GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.