Don’t Let Taxes Slash Your Gold Profits
Gold is a hot investment again. We were fortunate to add gold to our portfolios in August 2017. Since then, it’s done well. The price has increased steadily since late 2018, and we increased our allocation earlier this year.
Very easy global monetary policy, a lot of geopolitical uncertainty and other factors created strong support for gold that’s likely to continue. My recommended gold investment, the exchange-traded fund (ETF) iShares Gold Trust (IAU), is up more than 26% over the last 12 months and about 11% so far in 2020.There are a lot of ways to invest in gold, and there are different tax consequences for each of these methods. Gold investors aren’t going to have equal after-tax returns, and part of the reason is the differing tax treatments of the ways to invest in gold.
Consider the tax effects of different choices before deciding how to own gold.Bullion. There are several ways to own gold bullion, and it seems new ways regularly are developed. You can buy gold bullion bars directly. You can store the bars yourself or have them stored at a facility. Bullion coins, such as Krugerrands or American Eagles, also are an option. Exchange-traded funds are another way to own bullion that I’ll discuss separately.Bullion is a collectible under the tax code. That means it is ineligible for regular long-term capital gains treatment. Instead, long-term gains on bullion are taxed at a maximum 28% tax rate.
Collectibles, including bullion, also cannot be owned in an IRA, whether a traditional or a Roth IRA. The purchase of a collectible is a prohibited transaction and is treated as a distribution to the IRA owner. There is an exception for gold bullion coins that also are legal tender, such as the American Eagle coins. The amount invested in the collectible by the IRA is included in the owner’s gross income when the purchase was made, and there is a penalty for each year the investment stays in the IRA. If the owner is under age 59½ the amount of the gold purchased not only is included in gross income but also is subject to the 10% early distribution penalty, unless the owner qualifies for an exception to the penalty.
ETFs. Exchange-traded funds are the most liquid way to own bullion, though the ownership is indirect. The two main ETFs that buy and store bullion are iShares Gold Trust (IAU) and SPDR Gold Trust (GLD). These funds actually are trusts with interests that trade on the stock exchanges.You can buy and sell shares in an ETF on a stock exchange through a brokerage account. The ETFs charge annual expenses, and their returns are very close to the spot price of bullion minus the expenses.A big advantage of the ETFs is liquidity. You can sell the shares any time the markets are open and as quickly as any stock can be sold.
The ETFs generally trade at only modest premiums or discounts to net asset value. The IRS issued private letter rulings holding that the purchase of shares in an exchange-traded fund that owns gold or silver bullion is not the purchase of a collectible under the IRA investment rules. Instead, the investor is purchasing shares of a fund, because the shareowner does not have a legal claim on a share of the bullion held by the ETF and can-not force a distribution. So, an IRA or other qualified retirement plan is allowed to own the bullion ETFs, such as IAU.
But shares of the ETFs are considered investments in collectibles for purposes of the capital gains tax rules. When the ETFs are held in a taxable account, sales of the shares held longer than one year are taxable at a maxi-mum 28% rate instead of the standard long-term capital gains rate. The Private Letter Rulings are 200732026 and 200732027. The rulings were issued to the exchange-traded funds and are referenced in the “Tax Risks” sections of their prospectuses.
A unique gold ETF is VanEck Merk Gold (OUNZ). Like IAU and GLD, OUNZ owns gold bullion and stores it in vaults (in London in this case). The unique feature is that investors can redeem their shares for bullion or bullion coins. (There is a fee for redemptions below a minimum level.) Because of the ability to redeem shares for bullion, ownership of the ETF is treated as the direct purchase of a collectible under the tax code. It cannot be owned in an IRA or other qualified retirement account.Futures. You can trade gold futures yourself or own an ETF that does the trading, such as the PowerShares DB Gold Fund (DGL).
This fund buys a number of gold futures contracts that should have essentially the same return as a gold index the fund attempts to track, though there are anomalies in the futures markets that can cause deviations.The futures contracts aren’t considered direct ownership of gold, so they aren’t considered collectibles.Futures are taxed very differently from other investments, and for tax purposes the futures ETF is taxed to the owner the same way individual futures positions would be.
In futures ownership and trading, all gains are 60% short-term and 40% long-term, regardless of the holding period. In addition, the futures con-tracts are marked to market at the end of each calendar year, and the paper gains and losses determined.Investors must recognize on their income tax returns the net gains on the futures, whether or not the contracts are sold (or any distributions were made from the fund). With futures contracts, there is no deferral of taxes beyond the last day of the year. A further aspect of this fund is that it is organized as a partnership for a maximum 28% tax rate. tax purposes.
That means gains and losses pass through to shareholders’ tax returns each year. Net gains must be included in gross income, even if there weren’t any distributions and the investor didn’t sell the fund shares.Futures through ETNs. Exchange-traded notes (ETNs) are an alternative to ETFs. The investor in an ETN does not own the underlying asset. An ETN is a note, or debt, in which the note issuer owes the investor the initial investment plus or minus the return of an index, changes in the spot price of an asset, or some other named benchmark. As an example, the ETRACS CMCI Gold Total Return ETN (UBG) promises to pay the performance of the UBS Bloomberg CMCI Gold Total Return index after fees.
Some other ETNs promise to match double or triple the return of an index, while others offer the return of selling short gold.If the firm backing of the ETN has financial difficulties, the note might not be paid in full. Bankruptcy of the issuing firm could result in a complete loss. ETNs generally are backed by large banks or brokerage firms. You can buy ETNs that track the price of bullion and others that track the prices of futures contracts tied to bullion.
The ETNs are traded on the exchanges just like a stock.In general, an ETN is taxed the same as a bond. Upon a sale, the investor has a gain or loss that can be short-term or long-term, depending on how long the ETN was held. The belief of most tax advisors is that owning an ETN that tracks gold or other collectibles shouldn’t be considered a collectible for tax purposes. You shouldn’t be subject to the maximum 28% long-term capital gains rate for shares held longer than one year, and you should be able to own the ETN in an IRA. Likewise, if the ETN tracks futures contracts or the ETN issuer buys futures contracts to help meet its obligations under the ETN, the investor shouldn’t be treated as owning futures contracts.
Some ETNs make distributions while others don’t. Any distributions from the ETF are treated as interest income. But there is a lot of uncertainty about how ETNs are taxed because the IRS has not issued definitive rules. It issued a ruling in 2008 that raised more questions than it answered. The IRS has said it is considering a number of tax issues related to ETNs. It is likely that any new rules the IRS issues would be forward-looking.
Investors in ETNs before that date would be allowed the tax treatment just described.Equities. Instead of investing in bullion or futures, an investor can purchase the shares of companies that mine and produce gold and perhaps other metals. Shares of gold mining companies are far more volatile than the price of bullion, because mining companies have built-in leverage. Once the fixed costs of mining are covered, most of each dollar increase in the price of bullion goes to profits. Likewise, most of each dollar decline in bullion sharply reduces profits. In addition, the miners tend to borrow to finance their production, and that increases leverage.
Gold mining shares could be influenced by factors other than the price of gold. General stock market trends and economic conditions can influence the price of shares. For example, a new credit crunch that restricts miners’ access to capital could reduce production and profits even if gold bullion is soaring. Management competence of individual mining companies also can cause stock prices to deviate from the price of gold, as can economic and political events in the countries where mines are located.
For tax purposes, shares of gold mining companies are treated the same as other stocks, not as collectibles. Gold miners’ shares can be owned in an IRA. When owned in taxable accounts, they qualify for the regular maximum long-term capital gains rate when held for more than one year, not the collectibles tax rate. Shorter holding periods result in short-term capital gains.
Losses also are deducted the same as capital losses on other stock shares.Gold mining company shares can be purchased individually, through open-end mutual funds, or through ETFs.The returns of gold-related investments vary depending on the choice of investment vehicle. The tax treatment also varies between the vehicles, so investors’ after-tax returns can differ significantly even when the investments have the same pre-tax returns.
