Friday, August 12, 2011

Warning: Your Gold Might Be Taxable

For a variety of reasons, gold, precious metals, grains, and a variety of other commodities asset classes have been on a roll over the last several months. Some commodities like copper or iron ore soar in response to development and prospects for growth in the world economy. Other commodities, and gold in particular, rally when fear is pervasive in the global economy. If a country's sovereign debt has roiled out of control to the point where you might question the true value of its currency or its real purchasing power, then gold really shines. The extent to which all types of commodities have rallied is indication of the schizophrenia in today's global economy and financial markets. For everyday investors, a vast majority of this commodity exposure has come from allocations to funds that come with little known tax implications.

Commodity exchange-traded funds come in three varieties: funds that invest in bullion or the physical commodity held in a vault, funds that invest in futures contracts to garner commodity exposure, and exchange-traded notes that some financial entity issues to guarantee the performance of an index. Each type of fund has a separate tax consequence.

Funds that invest in the physical commodity to be held in a vault issue a tax form 1099, but they do not benefit from the reduced preferential long-term capital gains treatment, which is currently 15%. Instead, they are treated by the IRS as "collectibles", and taxed at the 28% rate attributed to collectibles. This collectibles rate is applied to any gain associated with owning the fund even if it were held over the twelve month period required to take advantage of the long-term capital gains rate.

A futures contract is a contract between two parties to exchange a specified asset at a specific established price today with delivery occurring at some specified future date. Investment funds seeking commodity exposure most commonly invest in futures contracts. There are several tax consequences associated with investing in these types of funds which are little understood. First of all, let's say that you bought a gold fund of this type in January of the year. And let's say the value of your fund increases 30% for the year. Well, even if you do not sell your fund at the end of the year, you are taxed on the market value of the fund at the end of the year. Imagine getting a tax bill without collecting the proceeds! As disruptive as this may be, the tax rate on the gains, regardless of the holding period, is 60% at long-term capital gains rates and 40% at short-term capital gains rates, which are substantially higher. To make matters even worse, this type of fund issues a K-1, which is very concerning because companies can issue the K-1 well into the following tax year, substantially beyond the issue date for the more common 1099 form.

Exchange traded notes are the third type of commodity-based fund. With these an issuer guarantees to match the performance of an index and issues shares in accordance with that guarantee. This type of fund is guaranteed by the financial viability of the issuing company. It is not protected by the price of the underlying commodity. It does however, issue a more favorable 1099 tax form and the gains that it generates qualify for the preferential long term capital gains rates.

The point of this outline is to be aware and educated, and to appreciate that the world of investing is not as simple as your father's Oldsmobile. Beyond supply and demand, and relative strength, and sector rotation, there are several underlying variables that can directly impact your returns. Without such knowledge, all that glitters may not be gold.

The opinions voiced in this material are for general information and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, you should consult a financial advisor prior to investing.
Past performance is no guarantee of future results.

The fast price swings in commodities and currencies will result in significant volatility in an investor's holdings.

Precious metal investing is subject to substantial fluctuation and potential for loss.

Principal risk: An investment in Exchange Traded Funds (ETFs), structured as a mutual fund or unit investment trust, involves the risk of losing money and should considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks: not diversified, the risks of price volatility, competitive industry pressure, international political and economic developments, possible trading halts, Index tracking error.

Structured notes may not be suitable for all investors and involve special risks such as risk associated with leveraging the investment, potential adverse market forces, regulatory changes, and potentially illiquidity. There is no assurance that the investment objective will be attained.

Investors should consider the investment objectives, risks, charges, and expenses of the investment company before investing. The prospectus contains this and other information about the investment company. You can obtain a prospectus from your financial representative. Read the prospectus carefully before investing.