Tax consequences for a U.S. person investing in gold
INVESTMENT INDUSTRY INSIGHTS |
As a result of recent years’ economic turmoil and uncertainty, it was not surprising that gold became a preferred investment. This increased demand in gold was clearly reflected in its rise in value. In October 2002, an ounce of gold was valued at $321.75. In October 2012, that same ounce was worth $1,787.00.1 Even with the recent pullback in value, at the time of this writing an ounce of gold was worth $1,368.90.2
While the rate of return on an investment in gold has been impressive over the past 10 years, investors should be mindful of the tax consequences of their gold investment decisions, and the structure used for their gold investments. Each investment vehicle may have different tax consequences translating into different after-tax rates of return, something all gold investors should consider.
To determine the tax consequences of an investment, investors need to understand applicable Internal Revenue Code sections. This article presents selected investment scenarios that utilize different gold investment vehicles and discusses their respective income tax consequences. When making investment decisions, gold investors should also consider the overall income tax environment, which has changed considerably in recent years and has the potential for future changes of similar or greater magnitude.
One major tax law change all investors should consider is American Taxpayer Relief Act of 2012 (ATRA). This legislation increased the marginal tax rates of many investors beginning in 2013. Additionally, as discussed below, a new 3.8 percent surtax on investment income changes the landscape for investors in particular.
The 3.8 percent surtax on unearned income and its impact on investors
One of the major changes imposed by ATRA is the 3.8 percent surtax on unearned income. As with other ATRA provisions, the surtax is generally effective for tax years beginning after Dec.31, 2012, and applies primarily to individuals, estates and trusts. While a full discussion of the surtax is beyond the scope of this article, every investor, including gold investors, should address its potential impact. For individuals, estates and trusts, the surtax applies to net investment income, after certain income thresholds are met.3 While the surtax generally applies to investment income, it may also apply to income from a trade or business in certain situations. Investments in gold and other metals are not excluded from the surtax.
The variables inherent in the application of the surtax make a uniform marginal rate application impractical for many taxpayers. While taxpayers with higher investment incomes may anticipate a 3.8 percent marginal surtax rate (on their net investment income), the impact of the surtax on other taxpayers may vary considerably. Because of this variability, the tax rates discussed and applied in the scenarios below do not include the 3.8 percent surtax. However, investors should be mindful that the surtax might very well apply, and consider modeling their after-tax returns to estimate its effect on their investment returns.
Gold investment scenarios
The investment scenarios below provide some basic guidance concerning the tax treatment of commonly utilized gold investment vehicles.
Scenario one – Gold bullion
Code sec. 1(h)(4) establishes that the tax rate on collectibles held for more than one year (long-term) can be taxed at rates up to 28 percent. Code sec. 408(m)(2) defines a collectible as:
Any work of art, rug or antique, metal, gem, stamp, coin, alcoholic beverage (e.g., vintage wines), musical instrument, historical object (such as a document or clothes) or other item of tangible personal property that the IRS determines is a collectible.
Since gold bullion is by definition a metal, the realized long-term gain on a direct investment in gold bullion can be taxed at rates up to 28 percent as compared to the normal 20 percent long-term capital gains rate.
Scenario two – Gold mining stocks
A direct investment in gold mining company stock will be taxed as a capital asset. Code sec.1221 generally defines a capital asset as most property held for sale. The capital asset definition excludes a few categories of assets that can be broadly summarized as most property held primarily for sale to customers in the ordinary course of a taxpayer's trade or business. Stock of a corporation purchased as an investment will qualify as a capital asset.
The tax treatment of capital gains and losses depends on whether the gains and losses are long-term or short-term, whether the taxpayer is a C corporation, and the type of asset sold. For noncorporate taxpayers, the maximum tax rate on net long-term capital gains is lower than the top ordinary income tax rate.4 The maximum tax rate on long-term capital gains depends on the type of capital asset sold, and the taxpayer's marginal tax rate (i.e., the top rate of tax on the taxpayer’s ordinary income).
Capital loss deductions are limited, but unused capital losses of noncorporate taxpayers may be carried forward indefinitely. Unused capital losses of corporate taxpayers can generally be carried back three years and carried forward five years. Corporate taxpayers should be aware of the carryover limits, as an expired capital loss will effectively decrease the after-tax return of an investment.
Scenario three – Gold held in an S corporation, partnership or trust
Code sec. 1(h)(5)(B) states that any gain(loss) from the sale of an interest in an S corporation, partnership or trust attributable to unrealized appreciation(depreciation) in collectibles shall be treated as gain(loss) from the sale or exchange of a collectible.
Therefore, long-term gain(loss) from the sale of an interest in a partnership, an S corporation or a trust attributable to unrealized appreciation(depreciation) in the value of gold is treated as gain(loss) from the sale of gold. As noted above in scenario one, for individual taxpayers the tax rate on long-term capital gain(loss) of physical gold can be taxed as high as 28 percent.
This look-through principle does not apply to C corporations; it only applies to S corporations, partnerships and other pass-through entities.
Scenario four – Grantor trusts and exchanged traded funds (ETF)
For U.S. federal income tax purposes, a grantor trust is a disregarded entity. As a result, a grantor trust is not subject to U.S. federal income tax. Instead, the trust’s income and expenses flow through to the trust beneficiaries. The beneficiaries are treated as if they directly owned a pro rata share of the underlying assets held in the grantor trust. Beneficiaries will also be treated as if they directly received their respective pro rata shares of the grantor trust’s income and proceeds, and directly incurred their pro rata share of the trust’s expenses.
To illustrate, an investment in a grantor trust holding gold bullion will be treated as if the underlying investor holds the actual gold. The long-term capital gain on sale of shares in the trust would be taxed at the 28 percent tax rate (as noted in scenario one above) and the long-term capital gain on gold sold by the trust will also pass-through and be taxed at the 28 percent tax rate. Net short-term gains would be taxed at the investor’s short-term capital gain tax rate.
A popular exchange-traded fund (ETF) that trades in gold is SPDR gold shares (GLD). In contrast to other ETFs, since GLD is structured as a grantor trust, the long-term gains are taxed at the potential rate of 28 percent. Net short-term gains are taxed at the short-term capital gain tax rate. However, a long-term realized gain on the sale of an ETF on gold mining stocks will be taxed at the preferential tax rate of 20 percent.
Scenario five – Regulated futures contracts and other exchange-traded derivatives
Code sec. 1256 requires certain types of contracts to be marked-to-market at year end (unrealized gains and losses are deemed to be realized), regardless of the taxpayer’s current tax elections. Under Code sec. 1256(a)(3) gains are taxed utilizing a unique rate – 60 percent of the gain is taxed as long-term capital gain and 40 percent of the gain is taxed as short-term capital gain. This creates an effective maximum tax rate of 27.84 percent [(40 percent of the gain x 39.6 percent) + (60 percent of the gain x 20 percent)]. This effective tax rate may be lower if the taxpayer’s ordinary income tax bracket is lower than 39.6 percent.
Code sec. 1256(b) defines the term "section 1256 contract" as including any regulated futures contract and any nonequity option.
An investment in regulated gold futures contracts, like all regulated futures contracts is governed by the provisions of Code sec. 1256 and profits are taxed as 60 percent long-term capital gain and 40 percent short-term capital gain.
“Nonequity option” is defined under Code sec. 1256(g)(3) to include any “listed option” (under Code sec. 1256(g)(5)) which is not an “equity option” (under Code sec.1256(g)(6)). An “equity option” is defined under Code sec.1256(g)(6)(A) and (B) as any option to buy or sell stock or any option the value of which is determined directly or indirectly by reference to any stock (or any narrow-based security index).
Thus, options on individual gold stocks (or on any narrow-based security index) are “equity options” rather than “nonequity options.” Therefore, they are not “Code sec. 1256 contracts” and must meet the normal one-year holding period to qualify for long-term capital gain treatment. Other listed options are “nonequity options” and the mark-to-market rules of Code sec. 1256 generally apply. These would include options on commodity futures and ETFs.
Investors have a variety of vehicles to choose from for their gold investments. As with any investment, the tax treatment should be taken into account when making an investment decision, as the varying tax rates will have a direct impact on the after-tax rates of return.
Investors should also monitor the legislative and political environment, since U.S. income tax laws are ripe for substantial change. As with the economy, pending tax law changes may significantly affect after-tax returns, and investment decisions, in gold and other assets.
- London Afternoon (PM) Gold Price Fixings.
- CEC: Commodities Exchange Centre, June 18, 2013 (Closing Price).
- See generally, Code Sec. 1411. All Code section references are to the Internal Revenue Code of 1986, as Amended, unless otherwise indicated. Regulation sections refer to the U.S. Treasury Regulations, as amended.
- As of 2013, the maximum tax rate on ordinary long-term capital gains is 20 percent. The tax rate on short-term capital gains is the taxpayer’s ordinary income tax rate (top marginal rate of 39.6 percent).