ETF Talk: Avoid the Tax Trap of Commodity ETFs

Exchange-traded funds (ETFs) are a great way to gain diversification and reduce money management costs that otherwise would cut the value of your holdings. But onerous tax problems have hit investors who have purchased certain commodity ETFs that use futures contracts. Investors that have purchased these ETFs are starting to express "shock and awe" on investment blogs about their unexpected tax liabilities. With sales of such commodity ETFs jumping so far this year, many investors may be piling into these investments completely unaware that they may be on the receiving end of a painful tax bite.

Keep in mind that this tax trap with commodity ETFs is a negative development in an ETF industry that is filled with many positives. Indeed, ETFs offer low expense ratios when compared to mutual funds and virtually any other investment. But we have uncovered a fairly serious tax problem for individual investors who are using taxable dollars for their commodity ETF purchases. If you are among those investors, read closely. If you are trading these commodity ETFs in tax-deferred accounts, you fortunately do not have this tax problem.

Those who most need to be concerned are investors in the PowerShares DB commodity ETFs and other ETFs that do not take delivery of the commodity itself. That is a different situation than what occurs with the purchase of streetTRACKS Gold Shares (GLD), an ETF that actually buys gold and stores it in a vault. But if you buy United States Oil (USO), for example, the fund uses futures contracts to get exposure to a commodity.

The reality is that commodity ETFs that use futures contracts have been set up as partnerships. When you own a position in a partnership, you are subject to taxes and will receive a K-1 tax form from the partnership. Investment blogs are warning that these commodity ETFs are creating tax nightmares.

One blogger on the DBA investment Web site advised never to trade a commodity ETF: "BEWARE OF THE HORRIBLE TAX NIGHTMARE."

The blogger, who used the moniker Grizz, shared the following:
-An investment in USO resulted in a trading loss of $741, with no interest received, but he received a K-1 form that reported a taxable profit of $9,136 and interest of $210.

-A trading profit in UNG of $1,900, with no interest received, generated a K-1 form that reported a taxable profit of $4,319 and $120 in interest.

-An enviable trading profit of $4,335 in DBA, without receiving any interest, triggered a K-1 that reported profits of $6,963 and $207 in interest.

-Modest trading profits in DBC of $337, with no interest received, led to a K-1 that reported profits of $3,406 and interest of $195.

It appears that commodity ETFs that use futures contracts are generating thousands of dollars of "phantom income" by incurring a tax liability without producing income. So far, I have identified a number of ETFs that fall into this tax trap situation. They include PowerShares DB Agriculture (DBA) and PowerShares DB Commodity Index Tracking Fund (DBC).

"Years ago, commodities generally were for hedgers and speculators," said Kevin Rich, a managing director at Deutsche Bank who directs its PowerShares DB commodity ETFs.

Unlike investing in equities, in which you own the stock until you decide to sell it, for individual investors, it is impractical to own the commodity if you invest in futures contracts, Rich explained. To stay invested in futures contracts, an investor would need to buy new ones to replace expiring contracts, he added.

The Internal Revenue Service (IRS) taxes futures investments differently than equity investments. In contrast to equities that remain unsold, holdings in futures contracts and T-bills are marked-to-market at the end of each year. As a result, there is a tax consequence on commodity ETF investments even if they have not been sold yet. This leads to the cost basis of these investments being adjusted at the end of each year, Rich explained.

One way to avoid these tax issues is to use an IRA or other tax-deferred accounts for commodity ETFs, rather than putting them into taxable accounts, Rich said.

Deutsche Bank had more than 380,000 different investors who owned its commodity ETFs in 2007, and each of them received a K-1 to complete their tax returns, Rich said. To assist those investors, Deutsche Bank provides a toll-free phone number, 1-800-578-8755, for them to call with any questions. The investment firm also tries to send out all of the K-1 forms it needs to distribute no later than the second half of February to help its investors ready their tax returns in time.

High returns for commodity ETFs since last year are helping to draw a significant amount of additional investment dollars into commodity ETFs. Institutional money also has moved into commodities in recent times because generally speaking, commodity investments do not exhibit a high correlation with overall market returns.

For commodity investors who do not want to receive K-1 forms that could surprise them with unexpectedly high tax liabilities, DB recently has begun to offer exchange-traded notes (ETNs) that invest in commodities. The returns of ETNs are reported on 1099 forms. The ETNs have the transparency of ETFs but the notes guarantee the investors a return that matches the index that they follow, Rich said.

Three gold notes were introduced by Deutsche Bank during February. Four agricultural notes were launched during the first half of April, while four diversified commodity notes were unveiled on April 29.

For investors who are concerned that commodities will not go up forever, Deutsche Bank recently began offering funds that allow investors to go short on these investments. These so-called inverse funds include leveraged products that give twice the exposure to losses or gains than the amount that is invested.

For investors who want to diversify into commodities, beware of the tax trap with funds that use futures contracts. If you want to steer clear of the year-end tax uncertainty, those who seek commodity exposure may want to consider using tax-deferred accounts for such ETFs or just buying ETNs.