...or how I lost money owning XYZ, and then got a big tax bill

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The answers are Probably, and Maybe.

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Of course, none of this is tax advice - even for the fictional ticker “XYZ”.

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I’ve heard the story many times of investors losing money in a quick ETF commodities trade, only to be surprised months later with a K-1 tax allocation. The fool.com has a humorous portrayal here. Like many puzzling phenomenon in ETF investing, investors will choose one fund over another over 0.01% in annual fees, but somehow the mystery of $2,000 of taxable income is quickly forgotten - and then repeated.  

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While the 2016 presidential campaign term “schlonged” (credit DJT) might seem the appropriate characterization for getting taxed on someone’s else’s gain, the reality is more complex and less awful.

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General ETF Tax Principles.

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Many ETFs create and redeem their shares through “in-kind” transactions, where dealers who transact directly with the fund essentially deposit or withdraw actual securities from the fund in exchange for the fund’s ETF shares. In brief, because a fund doesn’t generally sell securities (but rather ships them out in exchange for its own shares in a redemption), and because these “in-kind” transactions are generally non-taxable, gains which would otherwise be taxed are avoided. Any remaining taxable gains must be allocated to investors, but those remaining gains are usually minimal.

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In contrast, those ETFs which transact directly in futures or derivatives cannot avail themselves to in-kind exchanges - generally these funds regularly trade their positions and they regularly create taxable gains and losses. Because the tax needs to be paid, and because these funds seek to minimize multiple layers of taxation, taxable items which would otherwise be borne at the fund level are allocated to the fund’s investors (based on proportional holdings). Holders of these funds usually receive a K-1 allocation of the fund’s taxable items.

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So how does an investor that took a loss in a fund’s shares get tagged with a fund’s taxable gains?

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What’s Going On In These Funds?

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Similar to scheduled roll/trading dates, these funds also  identify a schedule of taxable income allocation; this schedule is usually detailed in the fund’s prospectus  - look for the “tax consequences” section or search for phrases such as “monthly allocation” and “in proportion to”.

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Many funds have adopted a monthly schedule which is based on “the last trading day of the immediately preceding month” -  this means that if you hold shares on November 30th, even if you sell your shares on December 1st, you are allocated the fund’s taxable items for the entire month of December. Similarly, if you acquire shares in early December, but sell them prior to the end of December, you will be allocated none of January or December’s taxable items. When a fund’s taxable items are allocated based on a single day’s holding from the prior month, taxable items and ETF-share market results may have little relationship. Revisiting the earlier example, where an investor holds shares in November (including the last day) and sells early in December, and where November stinks and December is great, a share loss accompanied by a tax allocation is likely.

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How Is This Reasonable?

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In the example where an investor pays $10,000 for ETF shares, sells them for $8,000, and then gets a $2,000 K-1 allocation, the K-1 allocation presents both a tax bill (bad) and an increase to the investor’s tax basis (good). So while our investor’s taxable income has increased by $2,000, our investor’s tax loss has also increased by $2,000 (i.e. 2,000 is added to the cost basis of $10,000 for a tax loss of $4,000; 12,000 - 8,000) - our investor has “traded” $2,000 in additional income for an additional $2,000 in tax losses.

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Two related and general principles of partnership (K-1) taxation include: (i) taxable income allocations are generally added to one’s tax (cost) basis, and (ii) distributions of cash or property are generally deducted from one’s tax (cost) basis.

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Because different funds have different underlying assets, and different underlying assets generate different kinds of income (e.g. precious metals funds have different taxation than crude oil funds), it’s hard to generalize about the K-1 impact. Similarly, because different investors and different holding periods will cause different types of gains and losses on ETF sales, it’s hard to generalize about the impact of ETF taxable trading gains or losses. Cautioning again, that this is not tax advice, an investor may find himself with a mismatch of non-offsetting gains and losses, and possibly a tax loss carryover for next year.  Uncle Sam is generally more excited to share your gains, and less excited to participate in your losses - tax character asymmetries (e.g. ordinary vs. capital) and limitations on certain tax items usually tip in favor of Uncle Sam.

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What to Do.

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Again, cautioning that none of this is tax advice, investors in all ETFs are encouraged to keep accurate records of cost bases (the plural of basis!), allocated tax items, and the character of the gains and losses their portfolio is generating. Additionally, investors should be sure to record and track carry-over items. In other words, don’t blindly download brokerage statements or blindly enter K-1 items into your return.

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