Tax planning for exchange-traded funds

Like some mutual funds, exchange–traded funds (ETFs) offer investors a simple method of investing in portfolios of stocks that closely track the performance and dividend yield of specific indexes. ETFs give investors the opportunity to buy or sell an entire portfolio of stocks in a single security, as easily as buying or selling a share of stock.

ETFs are similar to traditional mutual funds in that they are an investment structure that pools the assets of its investors and uses professional managers to invest the money to meet clearly identified objectives, such as current income or capital appreciation. Unlike mutual funds, ETFs are traded like other listed stocks. An ETF is created when an institutional investor deposits securities into the fund in exchange for creation units. In return for the deposit, the institutional investor receives a fixed amount of shares, some or all of which may be traded and priced throughout the day on a stock exchange. Noninstitutional investors (e.g., individual investors) do not purchase or redeem ETF shares directly from the fund. They buy or sell ETF shares on the stock exchange in the same manner they would purchase or sell any other listed stock.

All the buying and selling methods and strategies associated with stocks (e.g., market orders, limit orders, stop orders, and buying on margin) can be used when buying or selling ETFs.

The price of an ETF usually approximates but is not directly linked to the underlying net asset value of the fund. When demand for fund shares exceeds supply, the market price at which an ETF trades may be higher than its underlying net asset value. The reverse is also true.

Some of the benefits of investing in ETFs include the following:

• No sales loads: Many mutual funds normally include a sales load, or fee, with each purchase. ETFs do not include a load; however, brokerage commissions still apply to the same extent they would to the purchase or sale of any other stock.
• Ability to buy and sell at any time during the trading day: Unlike open-end mutual funds that can be redeemed only at the end of the day, ETFs are priced throughout the day and can be bought or sold just like a stock.
• Ability to buy on margin: This cannot be done with mutual funds.
• Ability to sell short: This cannot be done with mutual funds.
• Instant exposure to a diversified portfolio of stocks: There are ETFs representing broad-based market indexes, specific industry sectors, and specific geographical sectors.
• Relatively low management fees: Expense ratios for ETFs are often lower than for many open-end mutual funds. Usually, they range from 0.15% of the value of the fund to 1%.
• Tax efficiency: ETFs provide a tax advantage not available with mutual funds. Mutual funds sell securities to cover redemptions. These sales create capital gains, which are distributed to the owners of the fund. ETFs transfer securities out to redeeming shareholders (i.e., authorized participants) instead of selling the securities, thus minimizing taxable capital gains. Retail investors who want to liquidate shares in an ETF simply sell them to other investors through exchange trading. Because of this unique structure, ETFs are not required to sell stocks to meet investor cash redemptions, which can potentially generate capital gains tax liability for the remaining investors.
• Diversification: By owning an ETF containing the stocks in an entire market index or industry sector, an investor owns a large, diversified number of companies, which gives a degree of protection in case the price of one company in the index goes lower.

Harvest tax losses using ETFs

Where a taxpayer sells stock at a loss and repurchases the same company’s stock within 30 days, the capital loss on the sale of the original stock must be deferred. In this scenario, the new stock is substantially identical to the original stock (the same company) and thus triggers the wash–sale rules.

Example 1. Triggering the wash-sale rules: E sells 500 shares of I, a manufacturer of tablet computers and peripheral equipment, at a loss of $5,000. Three weeks later (less than 30 days), he reads a large brokerage firm’s report indicating that tablet computer sales are expected to increase substantially during the next year. That same day, E purchases 500 shares of I to take advantage of any potential price appreciation. Because E subsequently purchased stock substantially identical to the stock he originally sold less than 30 days before, the $5,000 capital loss from the original stock sale must be deferred because of the wash–sale rules.

The wash–sale rules and required capital loss deferral can be avoided when the new investment (made within 30 days) is not substantially identical to that original investment. If a taxpayer believes that a company’s stock that was originally sold at a capital loss less than 30 days ago once again represents a good investment opportunity, the taxpayer can purchase stock of another company in the same industry as an alternative to repurchasing stock in the same company. In this case, the new stock is not substantially identical to the original stock; therefore, the purchase does not trigger the wash–sale rules or restrict capital loss recognition on the original stock and theoretically preserves the opportunity for appreciation if the new stock does well.

Example 2. Avoid the wash-sale rules and maintain the capital loss: Using the fact situation in Example 1, if E purchased stock in P, another company in the same industry sector as I, to replace his original I stock, the $5,000 capital loss from his original I stock sale would be maintained. In this scenario, the wash–sale rules do not apply because the replacement shares in P are not substantially identical to the original shares inI.

As shown in Example 2, the taxpayer can avoid the wash–sale rules, maintain a capital loss from an original stock sale, and have an opportunity for price appreciation by reinvesting (within 30 days) in the stock of a different company in the same industry sector. However, companies within the same industry sector are often similar in some aspects but significantly different in others. Where no acceptable alternative individual company in the same industry sector represents a viable investment option, investing in a related–industry ETF may be advantageous.

Where a taxpayer sells stock in an individual company at a loss and within 30 days purchases the stock of an ETF in the same industry sector as the original company, the wash–sale rules are avoided, and the capital loss from the original sale is preserved, since an industry ETF is not substantially identical to any individual company. In addition, by investing in the industry ETF, investors preserve the potential for appreciation if the industry performs well.

Example 3. Use ETFs to harvest tax losses: M sells 900 shares of L, a software developer, with a current market value of $27,000 at a loss of $9,000. One week later, she reads an article indicating software application sales are about to boom because of new artificial intelligence (AI) developments that business users will require. M does not want to miss the opportunity for investment gains resulting from the new technology and software sales but wants to avoid the wash–sale rules and use her $9,000 loss on L to offset gains she has made on other investments this year.

As an alternative to reinvesting in L, M considers investing in P because P is also developing AI applications. However, P also develops and sells desktop games and music streaming services and sells music online. After completing her research on P, M is concerned that one or more of P’s other business lines will falter and offset any profit from its AI developments.

BecauseMcannot find a viable individual company replacement within the same industry as L, she decides to reinvest her $27,000 in C. C is a listed and actively traded ETF with investments in 15 software development companies, including five that have major developments in AI. By investing in C, M preserves her $9,000 capital loss on L since C is not substantially identical to L, and thus she avoids the wash–sale rules. She will also have the opportunity to participate in any price appreciation ofC.

The IRS has not defined the term “substantially identical.” Until there is definitive guidance on what the IRS believes is substantially identical, the percentage of ownership the ETF maintains in the stock initially sold at a loss could be called into question. Practitioners should monitor this matter and watch for further guidance in this practice area.

Commodities ETFs

Commodities listed on U.S. futures and securities exchanges are traded in various forms as ETFs. These ETFs are designed to track the investment performance of commodities such as silver, gold, platinum, copper, crude oil, and certain currencies. Commodity–based ETFs have historically been organized and operated as grantor trusts and limited partnerships. As a grantor trust, the ETF will generally be treated as a disregarded entity for federal income tax purposes. Practitioners should note that the tax treatment for commodity–based ETFs can be quite different from that of the more traditional ETFs.

Special tax considerations for precious metals ETFs organized as grantor trusts 

An investment in a precious metals bullion–based ETF may be considered a direct investment in a collectible (Sec. 408(m)(2)(C); Program Manager Technical Advice 2008–01809). If it is considered a collectible, any long–term gains on the precious metals ETF held more than one year would be taxed at a maximum rate of 31.8% (28% + 3.8% net investment income tax (NIIT) (Secs. 1(h)(4) and (5) and Sec. 1411(a))).

In addition, collectibles are generally not permitted investments for individual retirement accounts and participant–directed Sec. 401(a) qualified plan accounts. Therefore, any direct investment in a precious metals ETF could be considered a taxable distribution equal to the cost of the collectible (Sec. 408(m)(1)). However, exceptions apply for certain coins and gold and silver bullion (see Sec. 408(m)(3) and Letter Rulings 200446032, 200732026, and 200732027).

Finally, favorable Sec. 1256 treatment is generally not available for precious metals ETFs that are not backed exclusively by futures contracts.

Special tax considerations for foreign currency ETFs organized as grantor trusts 

In general, foreign currency gain or loss is computed separately and treated as ordinary income or loss (Sec. 988(a)(1)). Therefore, any gain or loss on the sale of a foreign currency–based ETF or currency contracts within the ETF will be considered ordinary income or loss for federal income tax purposes.

Ordinary treatment of losses can be favorable, since the Sec. 1211(b) annual capital loss limitation will be avoided. However, any ordinary gains are subject to a tax rate as high as 40.8% (37% + 3.8% NIIT). Similar to the precious metals ETFs, favorable Sec. 1256 treatment is generally not available for physically backed currency–related ETFs.

Special tax considerations for crude oil ETFs organized as limited partnerships 

Favorable Sec. 1256 (60/40) treatment of long– and short–term capital gain should apply for domestic oil futures contracts traded by a crude oil ETF organized as a limited partnership. This treatment will be reported on the investor’s Schedule K–1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc., for the tax year. Additionally, a sale will result in gain or loss on the actual ETF shares and be treated as short– or long–term capital gain, depending on how long the taxpayer held the investment.

Fixed-income ETFs

Fixed–income or bond ETFs operate very much like stock ETFs. They are actively traded, offer diversification, can be shorted, and offer low internal expense ratios. However, unlike stock ETFs, bond ETFs are generally not tax–efficient due to the regular income distribution schedule.

The movement of interest rates affects the value of bond ETFs similar to the way an individual bond is influenced. That is, there is an inverse relationship where rising interest rates cause a bond to decrease in value and vice versa. Bond ETFs generally distribute income monthly to investors. The monthly distribution changes regularly and in some cases may be reinvested, depending on the investor’s brokerage arrangement.

Contributor

Patrick L. Young, CPA, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org. This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s Individual Tax Planning topic. Published by Thomson Reuters, Frisco, Texas, 2026 (800-431-9025; tax.thomsonreuters.com).