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Hold commodities in a taxable account? Plan on getting a stiff bill from either the IRS or your accountant. Here are four ways you can get taxed.
Bullion. Precious metals are taxed as “collectibles,” much as if you were dabbling in baseball memorabilia. Short-term gains are taxed at your ordinary-income rate. Long-term gains are taxed at a maximum 28% federal rate. You owe tax only when you sell, and that deferral is worth something if you hold for a decade or two.
The big precious-metals funds are organized as trusts whose shares become collectibles: SPDR Gold Shares (GLD), iShares Gold Trust (IAU), iShares Silver Trust (SLV).
Futures. A futures contract traded in the U.S. is taxed as if you sold the position on Dec. 31 and bought it right back, an accounting scheme called “mark to market.” These paper gains and losses are presumed to be 60% long and 40% short, a weird formula whose architect, years ago, was a crooked congressman.
The 60/40 formula gives you a blended tax rate very close to the 28% rate on collectibles. But you don’t get any deferral with futures.
Partnership funds. The PowerShares DB Commodity Index Tracking Fund (DBC), U.S. Oil (USO) and other funds like them are partnerships. Paper gains and losses on their U.S. futures contracts flow through the fund onto your tax return via an irksome document known as a K-1. (London metals can get a different treatment.)
Your taxable profit will usually be inflated, or your loss reduced, by the amount of the fund’s management fee, since that fee becomes a not very useful “miscellaneous” deduction on Schedule A. This rule was put in place by some congressmen who might have been honest but weren’t thinking clearly.
The 60/40 treatment of gains, assuming you have gains, is particularly desirable for taxpayers who are sitting on capital losses. Let’s say you lost $1 million investing in a shopping mall, and are now making $100,000 a year off a commodity fund organized as a partnership. The partnership gains, married to your capital loss carry forward, effectively become tax-free for a decade.
K-1-free funds. This newer breed of commodity product erases the K-1 and replaces it with a simple dividend. Examples: PowerShares Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC) and U.S. Commodity Index (USCFX).
But simplicity comes at a fearsome price, warns Jeffrey Sion, a tax lawyer at Dechert. The erasing mechanism converts capital gains into high-taxed ordinary income, and it causes net capital losses for any year to vanish into the ether.
Example: You buy an ETF at $10. It sinks to $8 the first year and then rebounds to $11 the next. The fund cannot carry forward the $2 loss incurred in the first year. In year two, the IRS forces the fund to disgorge onto you a $3 distribution of ordinary income. At that point you can sell the ex-dividend share for $8, capturing a $2 long-term capital loss. But the loss cannot be used to offset the distribution.
Suppose, again, that you have a $1 million loss carry forward and now start making $100,000 from your K-1-free fund. You can use the capital loss to shelter only $3,000 a year of your commodity profits. It will take you 333 years to break even on the taxes.
What’s the moral here? That most investors should park a commodity fund in a tax-deferred account. Inside an IRA, a commodity fund is treated like a stock or bond: Gains and losses pile up untaxed until you pull money out in retirement. You don’t have to keep track of a cost basis and you can ignore the K-1.
Inside an IRA, a K-1-free fund would be harmless. But so would a partnership commodity fund. Master limited partnerships that own things like pipelines are in part debt-financed, and that can poison an IRA with “unrelated business income.” Commodity funds don’t have debt, and so the usual admonition about keeping partnerships out of an IRA does not apply here.
If you must own a commodity fund in a taxable account, limit your choices to bullion funds and partnerships.
via HSN