Leveraged ETFs and the tax on their "Capital Gains" - painful if not held in an IRA. .
By Matthew Hougan -- December 11, 2008 -- seekingalpha.com
A number of Rydex ETFs made large capital gains distributions this week. In the piece, I focus on one fund, the Rydex 2X S&P Select Sector Energy ETF (NYSEArca: REC), which paid out 86.61% of its total net asset value in short-term capital gains.
As discussed in this linked article, . indexuniverse.com
that's bad news for shareholders, because the payout is treated as ordinary income on their returns. That means a shareholder who held $10,000 of REC on Dec. 9 will have to pay income taxes on an extra $8,600 this year. Ouch.
A number of readers wrote wondering whether investors could simply sell shares of REC after the fund went ex-dividend and use losses from that sale to offset the distribution.
The idea has intuitive appeal. In this case, REC paid out $87 per share in short-term capital gains; investors will receive this money as a cash payment from Rydex. Reflecting this, REC's share price fell from $100/share to around $13/share this week. An investor who bought shares at $100/share (or thereabouts) earlier this year can now sell them for $13/share, and collect an $87/share short-term capital loss.
Unfortunately, this loss cannot be used to directly offset the capital gains distribution paid by Rydex.
The reason, like all things in taxes, is complicated. But it's also important.
Despite the name, "short-term capital gains distributions" from mutual funds do not count as short-term capital gains on individual tax forms. Rather, they are treated as "ordinary income"—essentially a nonqualified dividend payment from the mutual fund.
By contrast, short-term capital losses from selling a fund after its price declines are treated as traditional short-term capital losses. These losses can be used to offset short- or long-term capital gains realized elsewhere by an investor, as well as up to $3,000 of regular taxable income per year. But $3,000 is the limit: Beyond that, investors must carry forward additional losses into the future.
In the case of our aforementioned REC investor, who was paying taxes on an extra $8,600 in income, he can still sell REC and lock in a capital loss on the fund. However, he can only use, at most, $3,000 of that loss to offset the extra $8,600 in income, leaving him with an extra $5,600 in income to pay taxes on this year. It gets much worse as the numbers get bigger: If he had $100,000 in REC and faced an additional $86,000 in income, he still can only offset $3,000 of that amount.
Eventually, an investor can recoup his losses by using the carryover losses bit by bit, offsetting $3,000 in income and any other portfolio capital gains each year until the full value is used up. For now, however, he's stuck paying taxes out of pocket.
What makes this situation especially odd (and especially unfortunate) is that these rules only apply to short-term capital gains. If a mutual fund makes long-term capital gains distributions, shareholders can sell the fund and use capital losses to offset those distributions on a one-for-one basis. It is only on short-term gains where the offset is not allowed.
Strange? Yes. But no one ever said the tax system makes sense.
Another question I got was a smart one: "Who would take the other side of a sale in the days after a distribution estimate is announced and before it is paid?"
It's ia great question. In regular mutual funds, no one has to take the other side of a trade. You simply redeem your shares from the fund company, and any remaining shareholders in the fund are left to shoulder the distribution burden.
With ETFs, though, there are two sides to every trade, so someone must buy your shares when you're selling them. Who would do that before a big distribution? I can only imagine the answer is investors in tax-deferred accounts, institutions with more flexible tax situations and uninformed investors.
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