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A Tax Primer on Alternatives

Christine Benz
Timothy Strauts

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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Benz: So it's a trade-off. So, assuming that someone wants that GLD-type product in their portfolio one idea would be to potentially put it in say some sort of tax-sheltered wrapper like an IRA?

Strauts: Yes, GLD or IAU would be great products for an IRA.

Benz: In the past I know that one of rules about what you can't put it in IRA is that you can't put collectibles inside them. It sounds like these products, though, in fact are exempt from those rules?

Strauts: Yeah, I think the Internal Revenue Service came out with a ruling a few years back that exempted products like this from the collectible treatment as far as IRAs.

Benz: So let's take a look at another category that has seen explosion in investor interest. That's commodities. Let's first discuss what the thesis is for having commodities-tracking investments in your portfolio?

Strauts: Well, commodity investments, the main reason people add them is for the fact that they are not very correlated to the equity market. There is an academic paper that came out about 10 years ago that looked back in history and said if you had owned commodity futures contracts over time, you would've gotten equitylike returns with substantially lower risk and a noncorrelated asset.

So, after that paper came out, a lot of people said, "Hey, we should look at commodities for our portfolios as a diversifier." Well, they've done that recently and we've actually seen in the recent past since people invested in them that commodities are still a good diversifier, but not nearly as good a diversifier as they were 20 years ago. And the main reason is as more people invest in them, the diversification benefits start to go away.

Benz: We certainly saw that in 2008 where the correlations were in fact really similar to what you had with equities.

Strauts: Yes.

Benz: But I know inflation protection is another selling point at least for some investors with these types of products.

Strauts: Of course, yes. Because commodities are going to be based off of what people can pay, and as inflation goes up, commodities are going to go up, so they are a very good inflation hedge.

Benz: Let's discuss the tax wrinkles with commodities-tracking products. I know that it varies by product, but let's drill into some of the big headlines in terms of tax risks if you hold commodities-tracking investments.

Strauts: So, for one if you just own commodity futures--if you have a futures account and you own commodity futures--futures are taxed at 60% long-term and 40% short-term gains, and they're marked-to-market at the end of every year. So, every year regardless if you have to sell your investments, they mark the asset to market and whatever the gains are 60% long-term, 40% short-term.

Benz: And most of the ETFs in this space are set up as commodities-futures tracking investments; they are not investing in actual stuff?

Strauts: Yes, and the largest product and one we actually like is DBC, PowerShares DB Commodity Index. That owns a basket of diversified commodity futures.

Benz: If I own an investment like this, I should also keep it within the confines of an IRA or some other tax-sheltered vehicle? Is that my best option?

Strauts: It could be. It also depends on how much you trade. If you are a person who's going to be more tactical with your positions, there's no concern about short- or long-term gains anymore because you know at the end of every year, it's all going to be 60% long-term and 40% short-term. So, for some tactically minded investors, [you don't want it in an IRA because a short-term trade could get treated as 60% long-term capital gains.] But if you are going to be a buy-and-hold investor then, yes, the IRA is a good place. 6:35

Benz: The last category, this is really a sticky wicket, this is the MLP, master limited partnership space. There has been a true explosion of interest here especially among lot of our users. Let's discuss what the attractions are to this particular category.

Strauts: Well, there are two major attractions. One, high current income, master limited partnerships usually pay over 5% in income and annualized basis.

Benz: Hard to get that anywhere these days.

Strauts: Yeah. And two is that they are diversifiers. MLPs do not generally react the same way as equity markets do, and the main reason is that most MLPs are not part of the broad indexes than most people track. And so because they're not part of those indexes, they don't react the same way. So, they are very good diversifiers.

Benz: Let's drill into some of the big tax issues related to MLPs. I think we could talk about this for a lot longer, but let’s get into some of the big things that people should know before they buy any sort of MLP investment or a fund that invest in MLPs?

Strauts: I think first we [should] talk about if you actually buy an individual MLP directly. If you are buying individual MLP directly, you are buying, as it says, a master limited partnership, you are buying a limited partnership stake. So as a limited partner, you are going to receive a K-1 form at the end of every year. A K-1 is different than 1099, whereas your 1099s come at the end of January, early February, K-1s tend to come in late February, early March. So oftentimes people have to delay filing their taxes and sometimes even file for an extension just to get all their K-1s in. So, that's one thing.

But as far as the filing goes, it's not that much different than a 1099. It's a different form, and there are some different boxes on the tax form. But it's not actually that hard. The bigger concern is that with MLPs you might have to pay taxes in the individual states that the MLP does business. So, even if, say, you live in New York and the MLP does business in Oklahoma or some other state in the Midwest, you may have to pay state tax in those states because the MLP did business there because you are a limited partner and have an investment there. In general, I would recommend someone contact a tax professional in this area because it gets really complicated.

Benz: In terms of ETFs and ETNs that are set up to track the MLP market, let's talk about that area and whether you can get any reliefs from some of these tax headaches by investing in one of those well-diversified baskets.

Strauts: There are two basic options in the fund space. You can look at an ETF or an ETN, and I'd normally generally recommend is the ETN wrapper here because ETNs do not actually own the MLPs, so the ETN we recommend would be JPMorgan Alerian MLP, ticker AMJ.

Now, the JPMorgan fund does not actually own any MLPs. What it is, is you are essentially buying a debt security from JPMorgan that guarantees you the returns of the MLP Index that they have created. So, you get the returns of MLPs without actually having to own them so you don't have…

Benz: The K-1s filing and so on.

Strauts: The K-1s and the tax consequences. So, JPMorgan sends you the dividends, like you would receive them like you owned in an MLP. But that those dividends come in as regular income, a 1099 every year. So, you get a 1099 form instead of a K-1. And the with JPMorgan fund, it qualifies just like equity does; you can get short- and long-term capital gains. So, if you hold it for over a year, you can take advantage of long-term capital gains treatment.

Benz: So, if I am holding this MLP tracker within a taxable account, I know that in general MLPs have some nice tax-efficient benefits that make them a good fit for taxable accounts. Is that not the case with some of these products?

Strauts: That's the trade-off. So, if you own an MLP directly, when you get your distribution oftentimes, a very large percentage of that is actually considered return of capital, which is a great tax-deferral feature. Now, when you buy the ETN you lose that. The income you receive is straight income, and you have to pay regular income rates on that.

Benz: So, Tim, there is one other MLP tracker you want to talk about let's talk about that fund.

Strauts: Now, the last vehicle is the ETF vehicle, and the one in that space would be the ALPS Alerian MLP ETF, ticker AMLP. And this vehicle also avoids K-1s; you just get 1099s. But unlike the ETN it actually does own the underlying MLPs. But it's not structured as a regular open-ended fund like most people are used to. It's structured as a corporation, because, open-ended funds are not allowed to own more than 25% of their assets in MLPs.

So as a corporation, it has to pay tax at the corporate level, and so there's this deferred tax liability that the AMLP fund has to deal with. So, while the expense ratio is only 0.85%, when you add in the deferred-tax liability, the expenses end up being 4.86%, which is a massive drag on performance. So, in general, we tell people to avoid that and look at the ETN products, if you want a diversified vehicle.

Benz: So, can that ETN be held within an IRA, as well?

Strauts: Of course.

Benz: Tim, thank you so much for being here. Lots of complicated material to get through, but thanks for shedding some light on these issues.

Strauts: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz from