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By Christine Benz and Timothy Strauts | 02-27-2013 02:00 PM

A Tax Primer on Alternatives

Morningstar's Tim Strauts details the complicated tax treatment of MLPs, commodities, and other nontraditional assets, and offers several ETF and ETN picks along with another to avoid.

Christine Benz: Hi, I'm Christine Benz for Morningstar. Nontraditional asset classes are increasingly showing up in investors' portfolios, and some of them have tricky tax treatment. Joining me to discuss some of them is Timothy Strauts. He is a senior fund analyst with Morningstar.

Tim, thank you so much for being here.

Timothy Strauts: I'm glad to be here.

Benz: Let's take these one-by-one. Investors have really embraced some of these categories for their diversifying benefits. But let's look first at what they add to portfolios, what the tax wrinkles are, and then some potential workarounds for each category.

Let's start with gold bullion, which has become a really popular asset class, especially in the exchange-traded fund/exchange-traded note area where you focus. Let's talk about first what the thesis is for owning that gold bullion straight up as opposed to owning say gold-mining companies?

Strauts: Well, as you just said, gold has become very popular, say, in the last 10 years, and the main reason is that with all the central bank money printing that we've seen, many people feel that gold is the one hard currency out there. So, if you have a very small allocation to gold in your portfolio, you are sort of insulating yourself from the risk of much higher inflation in the future. Now, we've not seen any of that inflation, but it's just that risk that's always out there. So, we oftentimes recommend a 5% allocation to gold in many people's portfolios.

Benz: So, these products have really taken off. But there are potential tax wrinkles. Let's discuss that collectible tax rate that's there for owning gold bullion and talk about what's going on with gold and its tax treatment.

Strauts: Gold is taxed as a collectible, and under the tax code, collectibles are taxed at regular income rates up to 28%. So, if you are in the 15% bracket, you pay 15% tax on any gains you have in your gold securities. Now, if you're in the 35% bracket or 39% bracket, you only have to pay 28%, so it's capped at that level.

Benz: But that 28% rate is actually higher than the long-term capital gains rate for most taxpayers.

Strauts: Yes. And so owning gold, it doesn't matter how long you hold the asset. You don't have to worry about its short-term or long-term; it's all the same.

Benz: So how should investors think about managing that higher tax rate if they do decide they want a long-term allocation to gold bullion? Are there any workarounds? Any ways to mitigate that higher tax rate?

Strauts: Unfortunately, there is not any really good way to mitigate it. We would generally recommend looking at the different ETFs, the largest ETF being the SPDR Gold Shares, ticker GLD, and then iShares Gold, ticker IAU. Essentially they both own gold bars in a vault in London, so they're essentially the same structure, so we usually recommend the iShares fund because it has a lower expense ratio of only 25 basis points versus the 40 basis points of GLD.

Now, if you want to avoid the gold, you could go look at gold miners. So for gold miners the ETF we would recommend in that space would be GDX. Market Vectors Gold Miners has an expense ratio of 0.52%. So, the problem with owning gold miners, though, is that you don't get a very good correlation to actual gold because its equity securities, so you do get the collectible rates, but it doesn't track very well. If you look at the returns over the last year, gold is actually up in the last year, but gold miners are down pretty significantly.

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