Investors seeking to beat the market should look to exchange-traded funds (ETFs) for their tax efficiency. The ease of buying and selling ETFs, along with the low transaction costs, offer investors another efficient portfolio-enhancing tool. Tax efficiency is also an important part of their appeal, and is the one we'll focus on in this article. Investors need to understand the tax consequences of ETFs, so they can be proactive with their strategies.

We'll begin by exploring the tax rules that apply to ETFs and the exceptions you should be aware of, and then we will show you some money-saving tax strategies that can help you get a great return and beat the market. Read on to learn why these rules can remove restrictions in your financial life.

SEE: Introduction To Exchange-Traded Funds

General Tax Rules
ETFs enjoy a more favorable tax treatment than mutual funds due to the 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 you sell an ETF, 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, to receive long-term capital gains treatment you must hold an ETF for more than one year. If you hold the security for one year or less, then it will receive short-term capital gains treatment.

It's not all doom-and-gloom for mutual fund investors. The good news is that a mutual fund's generally higher turnover of shares creates more chances for capital gains to be passed through to the investors, compared with the lower-turnover ETFs.

SEE: Mutual Fund Or ETF: Which Is Right For You?

As with stocks, you are subject to the wash-sale rules if you sell an ETF for a loss and then buy it back within 30 days. A wash sale occurs when you sell or trade a security at a loss, and within 30 days after the sale you:

  • Buy a substantially identical ETF,
  • Acquire a substantially identical ETF in a fully taxable trade or
  • Acquire a contract or option to buy a substantially identical ETF

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

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, you can assume that any dividend you receive on common or preferred stock is an ordinary dividend unless the paying corporation tells you otherwise. These dividends are taxed when paid by the ETF.

Qualified dividends are subject to the same maximum tax rate that applies to net capital gains. Your ETF provider should tell you whether the dividends that have been paid are ordinary or qualified.

Exceptions - Currency, Futures and Metals
As in just about everything, there are exceptions to the general tax rules for ETFs. A good way to think about these exceptions is to know the tax rules for the sector. ETFs that fit into certain sectors follow the tax rules for the sector rather than the general tax rules. Currencies, futures and metals are the sectors that receive special tax treatment.

Currency ETFs
These are most currency ETFs are in the form of grantor trusts. This means the profit from the trust creates a tax liability for the ETF shareholder, which is taxed as ordinary income. They do not receive any special treatment, such as long-term capital gains, even if you hold the ETF for several years. Since currency ETFs trade in currency pairs, the taxing authorities assume that these trades take place over short periods.

SEE: Profit From Forex With Currency ETFs

Futures ETFs
These funds trade commodities, stocks, Treasury bonds and currencies. For example, PowerShares DB Agriculture (AMEX:DBA) invests in futures contracts of the agricultural commodities - corn, wheat, soybeans and sugar - not the underlying commodities. Gains and losses on the futures within the ETF are treated for tax purposes as 60% long-term and 40% short-term regardless of how long the contracts were held by the ETF. Further, ETFs that trade futures follow mark-to-market rules at year-end. This means that unrealized gains at the end of the year are taxed as though they were sold.

SEE: Modernize Your Portfolio With ETF Futures

Metals ETFs
If you trade or invest in gold, silver or platinum bullion, the taxman considers it a "collectible" for tax purposes. The same applies to ETFs that trade or hold gold, silver or platinum. As a collectible, if your gain is short-term, then it is taxed as ordinary income. If your gain is earned for more than one year, then you are taxed at either of two capital gains rates, depending on your tax bracket. This means that you cannot take advantage of normal capital gains tax rates on investments in ETFs that invest in gold, silver or platinum. Your ETF provider will inform you what is considered short-term and what is considered long-term gains or losses.

SEE: The Gold Showdown: ETFs Vs. Futures

Tax Strategies Using ETFs
ETFs lend themselves to effective tax-planning strategies, especially if you have a blend of stocks and ETFs in your portfolio. One common strategy is to close out positions that have losses before their one-year anniversary. You then keep positions that have gains for more than one year. This way your gains receive long-term capital gains treatment, lowering your tax liability. Of course, this applies for stocks as well as ETFs.

In another situation, you might own an ETF in a sector you believe will perform well. However, the market has pulled all sectors down giving you a small loss. You are reluctant to sell, since you believe the sector will rebound and you could miss the gain due to wash-sale rules. In this case, you can sell the current ETF and buy another that uses a similar but different index. This way you still have exposure to the favorable sector, but you can take the loss on the original ETF for tax purposes.

ETFs are a useful tool for year-end tax planning. For example, you own a collection of stocks in the materials and healthcare sectors that are at a loss. However, you believe that these sectors are poised to beat the market during the next year. The strategy is to sell the stocks for a loss and then purchase sector ETFs such as the S&P Materials Select Sector SPDR (AMEX:XLB) and Health Care Select Sector SPDR (AMEX:XLV). This way you can take the capital loss without losing exposure to the sectors.

SEE: Tax-Loss Harvesting: Reduce Investment Losses

The Bottom Line
Investors who use ETFs in their portfolios can add to their returns if they understand the tax consequences of their ETFs. Due to their unique characteristics, many ETFs offer investors opportunities to defer taxes until they are sold, similar to owning stocks. In addition, as you approach the one-year anniversary of your purchase of the fund, you should consider selling those with losses before their one-year anniversary to take advantage of the short-term capital loss. Similarly, you should consider holding those ETFs with gains past their one-year anniversary to take advantage of the lower long-term capital gains tax rates.

ETFs that invest in currencies, metals and futures do not follow the general tax rules. Rather, they follow the tax rules of the underlying asset, which usually results in short-term gain tax treatment. As a general rule, ETFs follow the tax rules of the underlying asset, which should help investors with their tax planning.

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