Gold is on investors’ minds again. The bear market that began in 2011 is over, and gold was up more than 28% in the first half of 2016. Gold could rise higher because of the consequences of Britain’s vote to leave the European Union and the potential for central bank mistakes.
Before adding gold to your portfolio, consider the tax consequences. Congress doesn’t like gold investments, so they receive special tax treatment. There are several ways to invest in gold, and each has its own tax treatment. You also can own gold in different types of accounts, which can change the tax results. Consider the tax effects of different choices before deciding how you want 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, and I’ll discuss those 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 the 28% tax rate.
Collectibles, including bullion, also cannot be owned in an IRA, whether it is 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’s an exception for gold bullion coins that also are legal tender, such as the American Eagle coins. The amount invested in the collectible 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). 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. The 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 don’t have premiums, discounts, or dealer markups.
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. Instead, the investor is purchasing shares of a fund, because the share owner does not have a legal claim on a share of the bullion held by the ETF and cannot force a distribution. Therefore, transactions in bullion ETF shares are treated the same as transactions in corporate stock or mutual fund shares, and they can be owned by an IRA.
The Private Letter Rulings are 200732026 and 200732027. The rulings were issued to the exchange-traded funds and are referenced in their prospectuses. A unique gold ETF is VanEck Merk Gold (OUNZ). Like IAU and GLD, it 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, ownership of the ETF is treated as a collectible under the tax code.
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 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 contracts 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). There is no deferral of taxes beyond year end with futures contracts.
A further aspect of this fund is that it is organized as a partnership for 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, the spot price of an asset, or some other named benchmark. If the firm issuing the ETN has financial difficulties, the note might not be paid in full. Bankruptcy of the issuing firm could result in a complete loss.
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.
Some ETNs make distributions while others don’t. Any distributions from the ETF are treated as interest income.
But there’s a lot of uncertainty about how ETNs are taxed, because the IRS hasn’t issued definitive rules. It issued a ruling in 2008 that raised more questions than it answered and said the IRS was 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.
There are several gold ETNs to consider. The ETRACS CMCI Gold Total Return ETN (UBG) is designed to track the performance of the UBS Bloomberg CMCI Gold Total Return index. Some other ETNs track double or triple the return of an index, while others offer the return of selling gold short.
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. They can be owned in IRA. When owned in taxable accounts, they qualify for the maximum long-term capital gains rate of 20% when held for more than one year. Shorter holding periods result in short-term capital gains. Losses also are deducted the same as other capital losses.
Gold mining 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.