While these new ETFs have provided investors with a myriad of opportunities to diversify their portfolios, they have also brought some surprising—and not altogether welcome—tax consequences. Unlike ETFs built on traditional equity or bond indexes, funds that hold currencies, futures contracts or hard assets such as precious metals receive different treatment under the U.S. tax code. Individuals looking to diversify into these areas need to know the sometimes arcane tax rules that govern these asset classes before they decide to commit their investment dollars.

Precious Metals

For investors seeking exposure to the precious metals markets, exchange-traded funds offer several ways to go. Some ETFs, such as the iShares MSCI South Africa Index Fund (EZA), are built on indexes heavily weighted toward gold and platinum mining companies. Others, such as the PowerShares DB Silver Fund (DBS), use futures contracts to gain precious metals exposure. (Futures contracts also receive special treatment by the IRS, which is discussed below.) The most direct exposure, however, can be found in funds that actually hold gold and silver bullion. Currently three funds—streetTRACKS Gold Shares (GLD), iShares Comex Gold Trust (IAU) and iShares Comex Silver Trust (SLV)—allow investors to do this.

The IRS taxes gains on equity-based ETFs just like any other mutual fund, stock or bond: for gains on ETFs held for a year or more, the long-term capital gains rate of 15 percent applies (5 percent for low-income investors). When it comes to actual gold and silver, however, the IRS takes a different approach. The tax code classifies metals—whether in the form of ingots, jewelry or coins—as “collectibles” and applies a different set of rules. Under the tax code as it currently stands, gains recognized from the sale of collectibles, including gold and silver (the rules also apply to art, antiques and other items) held for more than one year are taxed at a maximum rate of 28 percent. The maximum rate on short-term gains, i.e., capital gains recognized upon the sale of assets held for one year or less, is generally the shareholder’s ordinary income tax rate.

Investors who purchase ETFs that directly own precious metals should factor this into their overall investment strategy. One way to defer this tax bite is to hold precious metals ETFs in a tax-deductible IRA or a Roth IRA.

Futures

To avoid the adverse tax consequences of holding an ETF in gold or silver bullion, investors may instead turn to ETFs that use gold or silver futures to achieve similar results. The PowerShares DB Gold Fund (DGL) and PowerShares DB Silver Fund are examples of funds that seek to reflect the performance of the underlying precious metal using futures. But ETFs that use futures to achieve their results, whether they track gold, silver, corn, copper or currencies, come with their own tax twist.

Uncle Sam taxes futures contracts under a “mark to market” system. This is where things can get a little tricky—and where investors who hold futures-linked ETFs need to be careful. Under the terms of the tax code, futures contracts held at the end of the taxable year will be treated for federal income tax purposes as if they were sold at their fair market value. The net gain or loss resulting from these so-called deemed sales, along with the net gain or loss from any actual sales, must be taken into account by the ETF when it determines its taxable income for the year. ETF shareholders are on the hook for their pro rata share of the taxes on this income.

Now, if all this sounds alarming, then consider a few things. While the deemed sale might sound like a forced sale of an investor’s shares, it’s simply a legal fiction the fund must use at the end of the year to calculate its income. In addition, nearly all futures-based ETFs operate by “rolling” their contracts, i.e., by selling out of the current month’s contract before it expires, buying a future month’s contract and pocketing the difference between the two prices. In other words, futures-based ETFs are constantly selling and buying nearly their entire inventory of contracts, yet the latest distribution (on December 17, 2007) from the PowerShares DB Gold Fund, for example, was $0.81 per share. Again, investors can mitigate adverse tax consequences by holding futures-based ETFs in tax-deferred accounts.

Recent Ruling on iPath Currency ETNs

An exchange-traded note is a debt-based instrument that, like its ETF cousins, trades throughout the day on the secondary market like a stock. In December of 2007, the IRS issued a ruling on the taxation of a certain class of currency-based exchange-traded notes sponsored by iPath, a division of Barclays. In their simplest form, ETNs represent a promise by the issuer to pay the ETN holder the value of the underlying index plus interest at the maturity date. ETFs, by contrast, represent a fractional ownership in all the stocks of the underlying index.

It’s important to note two things: 1) The December 2007 IRS ruling applies only to the iPath currency-linked ETNs; and 2) The IRS doesn’t tax currencies the same way it taxes investments in debt or equity. The IRS treats currencies much like collectibles; in fact, it doesn’t really consider foreign currencies to be an investment at all.

Prior to the IRS ruling, the interest on the iPath currency ETNs was incorporated automatically into the price of the ETN, and ETN holders didn’t owe any taxes on this income until they sold their shares. Thus, as long as investors held the ETN for more than a year, the income would be taxed at the long-term capital gains rate of 15 percent. In the original prospectus materials for its currency ETNs, iShares was also telling investors that any additional long-term gains in the price of the ETN would be taxed at the capital gains rate. All that changed when the IRS weighed in last December.

In the wake of the December 2007 ruling, investors in the iPath currency-linked ETNs will owe ordinary income tax on income from these securities, even where this income is incorporated back into the value of the note. The bottom line for investors is that they will have to come up with this tax payment, even though they won’t actually receive that taxable income until they liquidate their position in the ETN.