ETFs and Taxes: What Are the Advantages of Ownership?

AdvisorOne writes: Q. What are the tax advantages of owning ETFs? One of the advantages of owning ETFs is their tax efficiency.  ETFs enjoy a more favorable tax treatment than mutual funds due to their unique structure. Mutual funds create and redeem shares with in-kind transactions that are not considered sales. As a result, they do not create taxable events. However, when you sell an ETF, the trade triggers a taxable event. Whether it is a long-term or short-term capital gain or loss depends on how long the ETF was held. In the United States, to receive long-term capital gains treatment you must hold an ETF for more than one year. If you hold the security for one year or less, then it will receive short-term capital gains treatment.   Planning Point: Long term capital gains are normally taxed at a favorable rate, at least for 2012.

As with stocks, you are subject to the wash-sale rules if you sell an ETF for a loss and then buy it back within 30 days. A wash sale occurs when you sell or trade a security at a loss and within 30 days after the sale you:

•Buy a substantially identical ETF,

•Acquire a substantially identical ETF in a fully taxable trade, or

•Acquire a contract or option to buy a substantially identical ETF

Planning Point: If your loss was disallowed because of the wash-sale rules, you should add the disallowed loss to the cost of the new ETF. This increases yourbasis in the new ETF. This adjustment postpones the loss deduction until the disposition of the new ETF. Your holding period for the new ETF begins on the same day as the holding period of the ETF that was sold.

Many ETFs generate dividends from the stocks they hold. Ordinary (taxable) dividends are the most common type of distribution from a corporation. According to the IRS, you can assume that any dividend you receive on common or preferred stock is an ordinary dividend unless the paying corporation tells you otherwise. These dividends are taxed when paid by the ETF as ordinary income.

Qualified dividends are subject to the same maximum tax rate that applies to net capital gains. In order to qualify:

1. An American company or a qualifying foreign company must have paid the dividend.

2.The dividends must not be listed with the IRS as dividends that do not qualify.

3. The required dividend holding period must be met.

The ETF provider should tell you whether the dividends that have been paid are ordinary or qualified.