The taxation of options on
exchange traded funds (ETFs) hinges upon both the structure of the
fund and whether the option is listed or over-the-counter.
on Mutual Funds– Listed options on Mutual Funds are taxed
“regularly” as a Mutual Fund is a corporation, specifically a
Regulated Investment Company (RIC). All early ETFs were setup as
RICs. Holding period of these options determines whether any
gain/loss is short or long-term. Gains and losses are only
recognized when the option position is closed or expired.
Note that for writers of these options, all gains or losses
will be treated as short-term regardless of how long the option
position is held open.
Options were first introduced, the government decided that Index
Options would not be taxed “regularly”, but instead be taxed
like futures contracts under IRC Section 1256. Congress coined the
term “non-equity” options to encompass these new Index Options
and any other listed options not on a single stock or a narrow
1256. The gains and losses are treated as 60% long-term and 40%
short-term capital gain/loss regardless of holding period. This
treatment applies regardless of whether the investor is long or
short the option. In addition, the options must be marked to the
market on December 31, all unrecognized gains and losses are
realized at year-end.
As an example, a
listed option on the S&P 500 ETF would be taxed regularly; an
option on the S&P 500 index would be taxed as a non-equity
option - a section 1256 contract.
All OTC options
are taxed “regularly”.
After all of the
ETF innovation in the marketplace, we find the number of options
that will be treated as non-equity options has grown. If the ETF
is not set up as a RIC, but as a trust (like GLD) or a limited
partnership (like USO), then listed options on the ETF would be
treated as a non-equity option under Section 1256.
maximize their after-tax returns from the use of options on ETFs
by using Section 1256 options if they plan on holding the option
for less than one year or if they are writing the options. If the
investor plans on holding the option for over one year, then
options on a corporate ETF or an OTC option would be preferable.
There have also
been a large amount of exchange traded notes (ETNs) issued with
their returns tied to various types of securities and commodities.
As long as the value of the ETN is not tied to a single stock or a
narrow based stock index, then listed options on ETNs should be
treated as Sec. 1256 contracts.