The unique tax consequences of exchange traded funds (ETFs) offer proactive investors a way to increase their returns.

One reason ETFs offer tax efficiency is their ability to create taxable events or sales.  When an ETF is sold, a taxable event is created and results in either a long-term or short-term capital gain or loss, depending on how long the ETF was held.  To make it even more attractive, an investor is able to pick up a capital loss, that may be otherwise lost due to wash-sale rules, by adding the loss to the underlying basis, or cost, of the newly purchased ETF.

Both of these characteristics allow an investor to defer taxes, states Hans Wagner of Investopedia. ETFs have been known to generate dividends, which are commonly the ordinary (taxable) type. They are typically taxed at a rate far lower than ordinary income.

In general, ETFs follow the above mentioned tax structure; however, one must also consider the exceptions to the rule, which can be found among ETFs that follow certain areas of the market.

• Currency ETFs are generally formed in grantor trusts, which results in any profit generated to be taxed as ordinary income to the ETF shareholder.
• Futures ETFs generally trade commodities, treasuries and currencies.  ETFs in this sector are taxed at 60% long-term capital gain rate and 40% short-term capital gain rate, regardless of how long the ETF was held.  Additionally, these ETFs follow mark-to-market rules at year end, which means that unrealized gains are taxed and not deferred.
• Metal ETFs are taxed as if they are “collectibles”.  What this means is that the advantages of normal capital gains tax rates on investments in metal ETFs are forfeited.

ETFs are a very useful tool for investors, allowing them to sell stocks to pick up tax losses and purchase sector ETFs to keep exposure to certain areas.  However, an investor must completely understand the tax ramifications of ETFs if used to enhance a portfolio.

Always be sure to consult your tax professional for advice about your specific situation.

Tags: Currency ETFs, Dividend ETFs, Sector ETFs