ETFS AND ETNS: TAX TREATMENT
EXCHANGE TRADED FUNDS AND NOTES
ETFS AND ETNS: TAX TREATMENT
EXCHANGE TRADED FUNDS AND NOTES
Understand how exchange-traded funds (ETF) and exchange-traded notes (ETN) are reported on your trader taxes.
CONTENTS
TAXES ON ETFS
Trading ETFs can have some definite advantages over traditional mutual funds. The sale of ETF shares creates a taxable event, with capital gains treatment similar to most stocks and bonds. Dividends and interest payments from ETFs are taxed similar to income from the underlying stocks of the ETF. Wash sale rules typically apply to ETF trading, unless the trader has elected Sec. 475 Trader Tax Status.
FUTURES AND COMMODITIES ETFS / SCHEDULE K-1
Futures ETFs (or commodities backed) are usually structured as publicly traded partnerships (PTPs). These ETFs typically issue annual Schedule K-1, passing through their underlying tax liability to the investor. Sales of futures ETFs are typically treated as capital gains and wash sale rules apply, except if a trader has elected Sec. 475.
What is done with a Schedule K-1? A trader invested in Futures ETFs may need to make cost-basis adjustments on Form 8949 in order to not double count some K-1 pass-through items. A common example: if the K-1 passes through Sec 1256 income to your Form 6781, then you should also add that income to the cost basis of the ETF shares on Form 8949 to avoid overstating tax liability. These adjustments are not made on the Form 1099-B.
PRECIOUS METAL ETFS—SUCH AS GLD, SLV, AND IAU—REQUIRE SPECIAL TAX HANDLING
Because of their tax structure, the income and expenses of these ETFs flow through to shareholders. Small sales of the physically backed precious metals (such as gold bullion) occur in order to pay monthly expenses. These sales are then passed on to the shareholders. As a result, shareholders of these ETFs may have small sales reported on the 1099-B throughout the year. These are often recorded as “principal” or “return of capital” by the broker. Because these pass-through sales are technically sales of precious metal, they are taxed at the “collectibles” long-term capital gains rate, currently 28%.
To learn more, please see information posted by our partners at Green Trader Tax: Tax Treatment of Precious Metals.
The small sales of the precious metal are not imported into TradeLog. Rather, they are handled separately for Schedule D reporting. Please see the IRS instructions for line 18 of Schedule D and the 28% Rate Gains Worksheet.
In addition, there may be adjustments that should be made to the cost basis of shares owned in the ETF. Shareholders should refer to tax guidance provided by the respective fund and/or tax advisor.
Links to popular precious metal ETF tax documents:
ETNS MAY HAVE DIFFERENT TAX TREATMENT DEPENDENT ON THEIR STRUCTURE
Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) are often grouped together since they have many similarities. ETFs represent a stake in an underlying commodity, therefore they are generally taxed like other securities realizing capital gains or losses, and IRS Section 1091 wash sale rules apply. However, ETNs are structured differently as a type of unsecured, unsubordinated debt security. ETNs don’t own any underlying assets of the underlying index or benchmark they are based on; therefore, different tax treatment may apply for some products.
The IRS has provided little definitive guidance on tax treatment for these products. However, leading tax experts have published strong support in recent years for their positions regarding ETN treatment.
Generally, we can categorize ETNs in three ways for considering tax treatment:
- Foreign currency ETN
- ETN structured as a debt security
- ETN structured as a prepaid forward contract (or prepaid executory contract)
Foreign Currency ETNs
The IRS has provided clear guidance for this type of ETN. In Rev. Ruling 2008-1 the IRS holds that foreign currency ETNs are considered debt for tax purposes, which results in the application of Section 988. Therefore, currency ETNs are treated as ordinary gain or loss. They cannot benefit from long-term capital gains rates and tax deferral.
TradeLog software segregates trades for Section 988 treatment. In the past, a trader would need to identify currency ETNs and manually change the type/multiplier for currency treatment. TradeLog now recognizes defined currency ETNs based on Trade Type Settings, flagging these with the type/multiplier code CTN-1. These trades will then be properly reported on TradeLog’s Forex/Currencies report, providing the needed details for Section 988.Trade T
ETNs Structured as Debt Securities
The structure of an ETN, as outlined in the prospectus, may be as a debt instrument/security. In this case the trades would be taxed like other securities, realizing capital gains or losses. Section 1091 wash sale rules would apply.
TradeLog Software recognizes defined ETF/ETN symbols based on Trade Type Settings. The type/multiplier code of ETF-1 is used for ETNs structured as debt securities. (This is the same treatment for most ETFs.) These trades will be reported on the Form 8949 generated by TradeLog. If Section 475 mark to market accounting (MTM) has been elected for the account, the software will then report these trades on Form 4797 (in which case wash sale rules will not apply).
ETNs Structured as Prepaid Forward Contracts (or Prepaid Executory Contracts)
Other ETNs are structured as prepaid forward contracts (also known as prepaid executory contracts), as evident by the ETN prospectus. These are based on the movement of an underlying financial instrument, futures index, or equities index – and do not hold stake in them. A number of popular volatility ETNs (like VXX) are known for such structure.
Prepaid forward contracts are not securities. They are taxed realizing capital gains or losses; however, Sections 1091 and 475 would likely not apply. This means wash sale adjustments would not be made on these types of ETN trades. If a trader has elected Section 475 MTM accounting, these ETN trades would not have MTM treatment. It should be noted that most prospectus documents will not address Section 1091 or 475 treatment, therefore consultation with a tax professional is advised.
TradeLog Software can identify ETNs defined in the Trade Type Settings for treatment as Prepaid Forward Contracts. The type/multiplier code of VTN-1 is used for classification. These trades will always be reported on the Form 8949 generated by TradeLog, and no wash sale adjustments will be made – regardless of whether an account uses MTM accounting method or not.
Options on ETNs
If you trade ETN options these may qualify for Section 1256 treatment if they are considered non-equity options. These are not reported on Form 8949, wash sale rules do not apply for these contracts, and the resulting gains/losses qualify for the beneficial 60/40 capital gains rates.
TradeLog Software can also identify ETN options that qualify for Section 1256 treatment and properly reports these like futures trades. The identifier FUT-100 is used to classify these trades. Please see the Exchange Traded / Broad-Based Index Options section to learn more.
Summary Chart for ETN Tax Treatment
| Type of Trade (TradeLog Class) | Tax Treatment | Wash Sale Rules Apply? | Sec. 475 MTM Eligible? | TradeLog Report |
|---|---|---|---|---|
| ETN – Foreign Currency (CTN-1) | Ordinary Gain/Loss (Sec. 988) | No | No | Forex/Currencies |
| ETN – Debt Security (ETF-1) | Capital Gain/Loss | Yes | Yes – with qualified election | Form 8949 (Form 4797 if Sec. 475 elected) |
| ETN – Prepaid Forward Contract (VTN-1) | Capital Gain/Loss | No | No | Form 8949 |
| ETN Option – Non-Equity (FUT-100) | 60/40 Capital Gains Rate (Sec. 1256) | No | Yes – with qualified election for futures | Section 1256 Contracts |
Challenges for Taxpayers
When it comes to ETNs other than those based on foreign currency, determination of tax treatment is not always very clear. Taxpayers may need to examine the ETN’s prospectus and consult with a professional tax advisor.
Broker-provided 1099-B reporting typically categorizes all types of ETNs as “securities” to be reported on Form 8949. And brokers usually make limited wash sale adjustments. The results could cause wash sale deferrals into the next tax year, which may increase tax liability – depending on the particular ETN structure this may be inaccurate. In the case of ETN options that qualify for Section 1256, the 1099-B reporting may cause a taxpayer to miss out on the beneficial 60/40 capital gains rates.
TradeLog Software Benefits
As discussed above, TradeLog can identify and properly report various types of ETN trades. As a result, traders can potentially reduce tax liability resulting from deferred wash sales and may benefit from the beneficial Section 1256 treatment of some ETN options.
Broker 1099-B reporting may not properly report ETN trades depending on their structure, as noted above. This could make it impossible to use the 1099-B alone for tax reporting. TradeLog can generate an accurate Form 8949 – and the other needed tax reports – including explanations for the IRS on the differences with 1099-B.
The Trade Type Settings determine treatment based on specified symbols and their classification. It’s important to note that default settings in TradeLog are based on researched opinions published by leading tax authorities but are not definitive. Remember that each taxpayer is responsible for the accuracy of their reporting. TradeLog provides the tools to help traders and investors generate the reporting they need.
ETF OPTIONS MAY QUALIFY FOR SECTION 1256 TREATMENT
Some ETF options may qualify as section 1256 contracts. Under Section 1256 the gains and losses are treated as 60% long-term and 40% short-term capital gains/losses, regardless of the holding period. What qualifies an ETF option as Section 1256 depends on it’s structure and whether the option is listed or over-the-counter. It’s nearly impossible to find a definitive list of ETF options and their tax status, nor does the IRS provide specific guidance. While most brokers do identify section 1256 contracts on 1099-b, they are not consistent with ETF options. Traders should carefully review any ETF options to ensure the best tax treatment.
The TradeLog Benefit for ETF Options:
TradeLog includes default settings to automatically classify section 1256 contracts for proper tax handling when importing the trade history from your online broker. These default settings include ETF options that most tax advisors recognize as qualifying for section 1256 treatment.
Based on IRS rules, section 1256 contracts must be marked-to-market at year end. TradeLog provides the functions needed for this special year-end accounting. Click here to learn more about how TradeLog handles section 1256 accounting. TradeLog also provides an easy-to-use report with the totals you need for completing IRS Form 6781 – which is where you report section 1256 contracts.