Mutual funds generate capital gains taxes each time they sell an underlying holding that has appreciated, even if an individual investor holds on to her fund. So that cost is passed on to her. By contrast, ETFs use an obscure tax loophole to cash in on appreciated holdings by swapping assets with a buyer — in this case, major banks.
For example, a fund sells an appreciated stock in its “basket” of shares to a bank and immediately buys back “substantially similar” shares. Because no cash has traded hands, there’s no capital gains tax on those profits. Or an ETF can sell a losing stock, deduct the loss, then buy back similar stock. The deduction boosts the returns of the fund. Of course, when an investor sells her ETF, she owes capital gains tax on the profits. But until she does, the capital gains taxes on internal trades made to keep the fund in line with its benchmark are “washed away.”
With active trading strategies, the tax perk for the new semi-transparent and opaque ETFs is even more significant. As well as potentially more prone to scrutiny. Sen. Ron Wyden, who heads the Senate Finance Committee, called in Sept. 2020 for an end to ETFs’ use of “in-kind” transactions to avoid triggering capital-gains taxes.
For example, a fund sells an appreciated stock in its “basket” of shares to a bank and immediately buys back “substantially similar” shares. Because no cash has traded hands, there’s no capital gains tax on those profits. Or an ETF can sell a losing stock, deduct the loss, then buy back similar stock. The deduction boosts the returns of the fund. Of course, when an investor sells her ETF, she owes capital gains tax on the profits. But until she does, the capital gains taxes on internal trades made to keep the fund in line with its benchmark are “washed away.”
With active trading strategies, the tax perk for the new semi-transparent and opaque ETFs is even more significant. As well as potentially more prone to scrutiny. Sen. Ron Wyden, who heads the Senate Finance Committee, called in Sept. 2020 for an end to ETFs’ use of “in-kind” transactions to avoid triggering capital-gains taxes.
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