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ETF Specialist

Your ETF Tax Questions Answered

What is a Schedule K-1?

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Many people decided to get out of exchange-traded notes over the past nine months due to 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.

The most notable use for ETNs was to gain commodity exposure, and the most popular means was previously  iPath Dow Jones-AIG Commodity Index (DJP). Many people sold DJP and other ETNs last year, and we completely understand why investors seeking commodity exposure would opt for a different investment vehicle during a dire economic climate for banks. We wrote about the credit issues regarding ETNs in our articles titled "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 regarding 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 exchange-traded fund 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 something new in the mail recently regarding taxation; a Schedule K-1. Most investors are used to receiving a Form 1099 for tax purposes, so first-time receivers of K-1 forms are often intimidated. 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.

Even those investors that have purchased other "shares" of publicly traded limited partnerships may be surprised to learn that DBC (and all other commodity trusts issued by PowerShares, excluding its ETN lineup) and USO (and all other commodity funds provided by its issuer) are structured as limited partnerships. Dealing with the issue in a taxable account may just seem like a bit more paperwork to these folks, but some have felt some unnecessary stress when the funds are held in a tax-deferred account, such as an IRA.

There is a special IRS clause regarding shares of publicly traded limited partnerships that can cause tax-deferred accounts to suddenly become taxable. The clause is known as Unrelated Business Taxable Income, and fear of being subject to this clause has lead many investors to avoid shares of limited partnerships in the past. The best examples of this case are pipeline companies, like  Kinder Morgan (KMP), which are often structured as Master Limited Partnerships rather than as corporations. The main difference between pipeline MLPs and funds like DBC and USO is that the pipeline MLPs engage in business activities to generate income. DBC and USO generate their income passively, or through investments in commodities. There are no "business" operations in these funds currently. So long as these funds maintain their current practices, the IRS has determined that they are not subject to UBTI.

Now that we have UBTI out of the way, let's talk about the general tax treatment of the aforementioned funds for individual investors. Caveat emptor: Before you read anymore, please be aware that I am NOT a registered tax advisor. Please understand that every tax situation is unique, so I cannot misrepresent my qualifications by saying that I can provide you with tax advice. You should consult your accountant for verification of your tax status regarding this (or any other) investment product. That said, I am going to discuss generally the tax ramifications for individual investors of the aforementioned funds in both a taxable brokerage account and a tax-deferred account, like an IRA. Again, every tax situation is unique, so these rules may not apply to you.

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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Paul Justice does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.