There are many different vehicles through which to own commodities, including gold, and there are different tax rules for them. Be sure you know the tax consequences of a commodity investment before adding it to your portfolio.
There are two basic ways to invest in commodities. (Options contracts are a third potential way, but they are more of a short-term speculation, so we won’t cover them here.)
One way to own a commodity is to buy the physical product outright, either directly or through a vehicle such as an exchange-traded fund (ETF). Physical ownership is common with gold, silver and some other precious metals but generally not with other commodities.
The general rule is that a commodity is a capital asset. When you sell, there is a capital gain or loss of the difference between your tax basis (usually the purchase price and any buying expenses) and the amount realized on the sale (usually the sale price minus any selling expenses).
When the asset is held for more than one year, there is a long-term gain or loss. A long-term gain is taxed at a
maximum rate of 20%. A short-term gain is taxed as ordinary income.
Capital losses are deducted against any capital gains for the year, and up to $3,000 of additional capital losses can be deducted against other income.
Losses in excess of that amount can be carried forward to future years. Capital gains and losses for the year are netted against each other to determine if you have a net gain or loss for the year and whether it is short term or long term. (See our June 2017 issue for details.)
There’s a special rule, however, that applies to some commodities because they are collectibles.
A collectible never qualifies for the lower long-term capital gains rate. Any gain from the sale of a collectible held longer than one year is taxed at 28%.
Precious metals are collectibles under the tax code. Bullion (such as bars of gold or silver), bullion coins and rare coins all are collectibles subject to the 28% tax rate. (The exceptions for holding collectibles in IRAs don’t apply here; all long-term gains from collectibles are taxed at the 28% rate.)
The other main way to invest in commodities is using futures contracts, and these have two special tax rules.
All futures contracts are treated as though they were sold on the last day of the tax year, even when they weren’t. This is known as mark-to-market accounting. Also, all the mark-to-market gains and losses from futures contracts are treated as 60% long-term and 40% short-term, regardless of the actual holding period.
Those are the basic tax rules for commodity investing.
There are many types of vehicles through which you can own commodities.
Trusts. The most common way to own physical precious metals now probably is through exchange-traded funds (ETFs). Many investors don’t realize the precious metals ETFs are legally organized as trusts. The IRS ruled the ETFs are very similar to direct ownership of the metals, so the ETF shares are collectibles for capital gains purposes. Long-term gains from selling the ETF shares are taxed at the 28% rate.
Pass-through funds. Most commodities ETFs are organized as partnerships or other pass-through entities. These are called pass-through entities because the fund doesn’t pay taxes. The income and gains pass through directly to the owners to be reported on their tax returns.
Also, most commodity ETFs invest using futures contracts. Mark-to-market accounting applies, so for tax purposes, gains and losses are tallied each year on futures contracts the ETF still owns at the end of the year. The 60-40 rule also applies.
There are three effects of a commodities ETF being a pass-through entity. One effect is the shareholders, not the fund, are taxed on the gains and losses each year, including the mark-to-market gains and losses. So shareholders are likely to report gains or losses even when they haven’t made any transactions in the fund’s shares.
The second effect is shareholders receive a tax form each year called a K-1. This is the equivalent of a mutual fund’s or brokerage firm’s 1099 form. But a K-1 is longer and to those who aren’t familiar with them, K-1s can be daunting and confusing. It will take you longer to prepare your tax return each year, or your tax preparer will charge more than for a return without K-1s.
The third effect is you might be required to file income tax returns in additional states because of the K-1s. The fund is required to file K-1s with every state in which it does business or has interests. Shareholders who have substantial investments in the ETF might reach tax return filing thresholds in more than one state, including states they never visited. This is less likely with a commodities futures ETF than with a fund that invests in operating businesses, such as master limited partnerships. But you should check with the fund before making a purchase.
Non-pass-through funds. Many investors learned to avoid commodity and master limited partnership investments because of the tax hassles. The financial services industry responded by offering vehicles that aren’t required to issue K-1s to investors and don’t pass through gains and losses.
These vehicles generally pay dividends and issue the 1099s with which most investors are familiar.
There are potential disadvantages to the non-pass-through funds.
These funds usually are organized as corporations. That’s why income and gains don’t pass through to shareholders, but it also means the funds are taxed at rates up to 35% of their net gains. They can pay dividends only on the income and gains left after paying corporate taxes and other expenses.
Also, the dividends usually are not qualified dividends with the maximum tax rate of 20%. The dividends are ordinary income, taxed the same as interest income.
Another disadvantage is that if the fund’s investments lose money one year, neither you nor the fund is likely to be able to carry the loss forward to the next year to offset future gains and income.
Finally, these entities usually have high expenses. You pay a lot to avoid the problems of pass-through funds.
Exchange-traded notes. There are a few exchange-traded notes (ETNs) that avoid many of the tax disadvantages and confusion of the other commodity investment alternatives.
You buy an ETN on the stock exchanges just like a stock. You own a capital asset. When you sell, you have a gain or loss, and a long-term gain is taxed at the maximum 20% rate. There are no taxes in the interim, unless the ETN pays a distribution. The distributions are taxed as ordinary income.
An ETN also is not considered an investment in commodities or precious metals. You’re buying a share of a note.
The potential downside of an ETN is that all you’re buying is shares of a promise of the issuer to pay investors the return of a stated index minus expenses. You can buy or sell the shares on the stock exchanges each day, so the ETN is liquid. But the financial strength of the issuer is a factor in the ETN’s value. If the issuer fails, the ETN has no value.
ETNs were becoming attractive before the financial crisis. But the financial crisis caused investors to worry about defaults on ETNs, and the financial instruments lost some popularity. There haven’t been many ETNs issued since.
Equities and mutual funds. To stay on familiar ground and avoid many of the tax issues we’ve discussed, one option is to invest indirectly in commodities by investing in commodity businesses.
For example, you can buy shares of gold mining companies or funds that invest primarily in those shares. Or you can own a collection of resource company stocks or a fund, such as
T. Rowe Price New Era, that invests primarily in companies engaged in natural resource businesses.
These stocks and funds often don’t have the explosive gains available from direct commodity ownership or futures, and you take company-specific risks, such as too much debt, poor management and labor relations problems.
IRA investors. Gold and commodity investments can create some other issues for IRA investors.
The main issue is that collectibles are prohibited IRA investments (both traditional and Roth IRAs). Precious metals, whether bullion or coins, are collectibles.
There are exceptions for certain forms of gold, silver, platinum and palladium. Specific bullion coins that are legal tender are allowed in IRAs. These include the American Eagles, Canadian Maple Leafs and a few others. Also excepted are precious metal bars and rounds produced by a NY- MEX- or COMEX-approved refinery or a national government mint. These bars or rounds also must meet minimum fineness requirements specified by the IRS. Most custodians that allow precious metals investments in their IRAs will ensure they meet the IRS requirements, though it is the IRA owner’s ultimate responsibility.
The other forms of commodity investments that involve futures and the various forms of funds aren’t prohibited for IRAs. Some that issue K-1s and are operating businesses, however, might generate unrelated business taxable income (UBTI) that is taxable to the IRA.
When choosing commodity investments, you have to do more than look at the return history of a vehicle. You need to look at its structure and unique tax factors. The best approach is to read the section of the fund’s prospectus titled “Federal Income Tax Consequences” or “United States Federal Income Tax Consequences.”