Filed Under:Life Insurance, Life Planning Strategies

10 things to know about how investments are taxed

Among the investment products advisors recommend to their clients, mutual funds and exchange-traded funds top the list. ETFs in particular are a popular product for thier tax-favored status — but how precisely are they taxed? What are the exceptions to the general rules? And what about dividends from mutual funds or real estate investment trusts? If you're looking for detailed answers to these and other questions, read on. 

1. What are the tax advantages of owning exchange-traded funds (ETFs)?

One of the advantages of owning ETFs is their tax efficiency. 

2. How are ETFs taxed?

ETF shares represent undivided interests in the assets held by the fund. ETFs are “organized either as open-end investment companies or unit investment trusts.” ETFs organized as unit investment trusts generally qualify for tax treatment as regulated investment companies for tax purposes. 

Exchange-Traded Funds Invested in Metals. In a memorandum prepared by the Office of Chief Counsel of the IRS, which was made public only as the result of a court order, the IRS advised that the sale of an interest in an ETF that directly invests in metal (“physically-backed metal ETF”) is treated as the sale of a “collectible,” such that any gain from the sale of the interest is subject to the maximum capital gain rate of 28 percent (i.e., instead of the 20%/15%/0% capital gain rate). The Service reasoned that in the case of a physically-backed metal ETF that is treated as a trust, the investor is treated as owning an undivided beneficial interest in the collectible held by the trust. Accordingly, if the investor sells an interest in the ETF or the trust sells a portion of the collectible, the investor is treated as having sold all or a portion of his or her share of the collectible held by the trust, and any gain from the sale of the trust interest or sale of the collectible by the trust is treated as collectible gain and, therefore, is subject to the maximum capital gain rate of 28 percent. However, if a physically-backed metal ETF is not structured as a trust, or if the ETF does not directly invest in the metal, then the above rule does not apply. The Service cautions that the structure of each physically backed metal ETF should be considered to determine the tax consequences of an investment in that ETF.

4. How are dividends received from a mutual fund taxed?

Mutual funds may pay three kinds of dividends to their shareholders; generally, taxable dividends will be reported to the shareholder on Form 1099-DIV.

(1) Ordinary income dividends. Ordinary income dividends are derived from the mutual fund’s net investment income (i.e., interest and dividends on its holdings) and short-term capital gains. A shareholder generally includes ordinary income dividends in income for the year in which they are received by reporting them as “dividend income” on his or her income tax return.

5. How is a mutual fund shareholder taxed on undistributed capital gains?

A mutual fund may declare but retain a capital gain dividend. If it does so, the mutual fund will notify its shareholders of the amount of the undistributed dividend and will pay federal income tax on the undistributed amount at the corporate alternative capital gain rate, which is currently 35 percent.

See also: Mutual funds among top products used by advisors

8. How is a shareholder taxed when he or she sells, exchanges, or redeems mutual fund shares?

When a shareholder sells, exchanges, or redeems mutual fund shares, the shareholder will generally have a capital gain or loss. Whether such gain or loss is short-term or long-term usually depends on how long the shareholder held the shares before selling (or exchanging) them. If the shares were held for one year or less, the capital gain or loss will generally be short-term; the capital gain will generally be long-term if the shares were held for more than one year. 

The gain or loss is the difference between the shareholder’s adjusted tax basis in the shares (see below) and the amount realized from the sale, exchange, or redemption (which includes money plus the fair market value of any property received). 

9. What are the general requirements that must be met in order for a real estate investment trust (REIT) to qualify for pass-through tax treatment?

As the name suggests, a real estate investment trust (REIT) is required to invest primarily in assets that are closely connected to real estate. Permissible investments include ownership interests in real property, interest derived from loans where the underlying asset is real property and investments in other REITs.

Importantly, a REIT is required to distribute 90 percent of its annual earnings to shareholders. A company that meets the requirements described below will qualify as a REIT, and therefore be allowed to deduct from its corporate taxable income all of the dividends that it pays out to its shareholders.Because of this special tax treatment, most REITs pay out 100 percent of their taxable income (rather than simply meeting the 90 percent requirement) to shareholders and, therefore, owe no tax at the corporate level.

10. How are proceeds on the sale or retirement of a corporate bond taxed?

(1) If the sale occurs between interest due dates, as it generally does, stated interest accrued to the date of sale but not yet due is customarily added to the purchase price. This must be included in the seller’s income as interest.

(2) Proceeds in excess of item (1), above, are recovered tax-free to the extent of the investor’s adjusted basis in the bond. As a general rule, the investor’s adjusted basis is the cost of acquisition adjusted by (a) adding any original issue discount included in income as it accrued (see Q 7634, Q 7636) and market discount included in income prior to the sale, or (b) subtracting amounts of premium deductible or applied to reduce interest payments if an election was made to amortize bond premium.

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Nichole Morford

Nichole Morford
Managing Editor

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