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Your Commodity ETF Tax Questions Answered

What is a Schedule K-1?

Paul Justice, 02/19/2010

Commodity fund investors have started receiving their Schedule K-1s in the mail recently, so we thought it would be a good time to review the pros and cons of the various exchange-traded fund structures from a tax perspective. Also, we'll discuss some of the issues to which investors will need to pay attention when they are preparing their 2009 tax returns.

Most investors are familiar with Form 1099 that accompanies many "1940 Act" funds (traditional mutual funds that hold equities). However, if you bought a commodity-futures-based ETF, you might have received a Schedule K-1 instead. While the form may be intimidating at first, it should not be perceived as a tax nightmare. We'll help you walk through the filing process later in the article.

If you acquired your commodity exposure through an exchange-traded note, then you won't have to deal with the extra filing headache. However, many people decided to get out of ETNs over the past two years because of their inherent credit-risk exposure. The duress of the backing banks fully justified such a move by savvy investors. After all, investors were seeking only the returns on their respective indexes. They were not seeking credit risk to financial institutions, nor were they compensated adequately by all ETNs for such risk.

In our view, most of the backing banks of ETNs have considerably better balance sheets today, so the tax advantages of ETNs over commodity-focused ETFs could lead many investors to the conclusion that ETNs are indeed a better bargain today. Investors need to weigh the benefits themselves, but we believe that total avoidance of the ETN structure today is no longer warranted. We have written about ETNs' credit issues several times, including in our articles "ETN Credit Risk Rears Its Ugly Head," "ETNs Demystified," and "Our New ETN Outlook."

The fall from grace of the ETN structure during the global financial crisis is unfortunate for investors. ETNs are the most tax-efficient and well-understood investment vehicles for gaining commodity exposure. Because you are taxed only upon sale of the fund under normal capital gains rates, the filing process is easy and efficient. (Every rule has an exception; currency ETNs are taxed at higher ordinary income rates upon sale.)

Here is a summary of taxation rules for ETNs (other than currency-tracking funds):

1. It holds no real assets; it's a promissory note.
2. You will be taxed only upon sale.
3. Short-term capital gains apply when held less than one year.
4. Long-term capital gains rates apply when held more than a year.
5. There are typically no dividends or interest income.

Perhaps you went a different route and decided to garner commodity exposure by purchasing an ETF like PowerShares DB Commodity Index Tracking Fund DBC instead of an ETN. You gained broad commodity exposure by going this route, but you likely received a Schedule K-1 in the mail recently. This form accompanies any investment in a Limited Partnership, which is the legal structure under which DBC was formed. Another popular limited partnership "ETF" that invests only in futures contracts is United States Oil USO, so the same rules would apply there.

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