Want to invest in more than just stocks and bonds? Your tax situation may get much trickier.
What follows is intended to be an informational discussion of tax basics and not personalized advice. Please consult your tax advisor if you are curious about implications in your specific case.
Bitcoin-the cryptocurrency conjuring a nearly endless stream of headlines-recently underwent a widely publicized spinoff. In an effort to increase liquidity, software developers mirrored original bitcoin's code and handed everyone who owned one bitcoin one new Bitcoin Cash.[i] Opinions of the transaction's merits run the gamut, but there is one opinion we think you should particularly mind: the US Internal Revenue Service's. You see, there is confusion over how this 1-for-1 spinoff will be treated for tax reasons. Does the receipt of Bitcoin Cash count as taxable income in 2017? Or will it be treated like most equity spinoffs, with taxation deferred until sale? To this point, the IRS has been mum-leaving Bitcoin Cash owners in tax limbo. Of course, the impact here is narrow-cryptocurrencies aren't common. But we think there is a lesson here for investors in unorthodox investments of all kinds: Get informed about potential tax implications before buying. To that end, here is an informational guide to some tax considerations for off-the-beaten-path investment products.
First, though, let's review how taxation typically works for investors in stocks outside of retirement accounts. Gains-the difference between what you paid for the stock (your cost basis) and the sale proceeds-are subject to capital gains rates. How long you owned the asset is key. If you sell a security within a year of buying it, short-term capital gains rates apply-and these match your ordinary federal income tax rate. Gains on securities held longer than a year qualify for typically lower long-term capital gains rates-usually 15% but sometimes 20%. (An additional surtax on net-investment income associated with the Affordable Care Act can boost these a bit more.) Dividend taxation hinges on whether they are "qualified" or not. Qualified dividends (which are taxed at capital gains rates) must be issued by US-based or US-listed firms and held for at least 60 days.[ii] Everything else is unqualified and taxed as income. Those are the basics. But if you veer into unconventional assets, there is much more.
One thing the IRS has made clear about cryptocurrencies: It considers bitcoin property, not currency. In some ways, this is a feature, not a bug-in currencies, 60% of profits count as long-term capital gains and 40% as short-term. So the property designation queues up possible savings. But the property classification also means you'll be liable for capital gains if you sell after it appreciates. "Selling" includes paying someone in bitcoin. This leads to uncomfortable questions, like:
Suffice it to say, bitcoin tax complications aren't limited to the recent spinoff.
Gold and Silver
The IRS treats gold and silver as it does art, cars, stamps, Beanie Babies and baseball cards-as collectibles. Short-term gains are taxed at ordinary income rates, similar to stocks and bonds. But long-term gains are taxed at 28%-higher than typical capital gains rates. Keep in mind this doesn't merely apply to commemorative gold coins or your grandmother's silver figurine collection. Gold and silver ETFs face it, too.[iii]
Business Development Companies (BDCs)
BDCs act as quasi-banks: They pool capital and lend to or invest in small and mid-sized private firms, distributing at least 90% of profits to shareholders. The result: high advertised yields that attract many. But those are distribution yields, not dividend yields-meaning they're partly composed of your original investment.
BDC distribution yields come in three forms:
Assuming you hold for a while, your cost basis could fall substantially, potentially increasing your exposure to capital gains taxes. For example, if you invested $1000 and over the course of your ownership, the BDC's returns $600 of your capital, your cost basis is now $400. So if the BDC is valued at anything greater than $400, you'll pay capital gains.
Two other notes of caution: First, banking-particularly lending to small businesses that may not be able to get bank funding-is risky. Sometimes investments don't work out or the economy tanks-and BDC distributions, like others, aren't guaranteed. Second, even if you are partial to BDCs, we caution you against the costly, illiquid, non-traded variety.
Master Limited Partnerships (MLPs)
These are publicly traded partnerships designed to encourage private investment in energy infrastructure-typically, pipelines. Like BDCs, they must distribute at least 90% of profits to shareholders. They're also marketed as offering tax benefits and high yields. But the same issues with BDCs exist here: Investors may delay but can't avoid taxes-and the high yields are usually partly due to returned capital, so exposure to capital gains can rise. If the cost basis falls to zero, this portion of the distribution is typically treated as a capital gain.
Maybe buying MLPs in a tax-deferred or exempt retirement account seems smart. But hold the phone: Holding MLPs in IRAs can bring a surprise. IRAs don't shield you from "Unrelated Business Income Taxes," which apply to profits from partnerships (like MLPs) in excess of $1,000. If you have a big stake in MLPs in an IRA, contact a tax advisor to better grasp this (and then probably diversify that big stake anyway).
While tax wrinkles are worth considering, it is arguably more important to remember concentrated exposure to any single industry is risky-a lesson owners of Energy-focused MLPs have learned painfully in recent years.
Real Estate Investment Trusts (REITs)
These pooled investment vehicles focus on real estate and possess similar tax advantages and disadvantages of BDCs. REITs are logically concentrated in Real Estate, so don't go overboard-and, again, the non-traded kind are highly undesirable, in our view. Moreover, like MLPs, certain REITs (mostly mortgage REITs) held in a retirement account may be subject to unrelated business income tax.
There are, of course, many more products that could further complicate your tax situation. Consult a tax professional if you own or are considering buying any of these unconventional investments. Forewarned is forearmed-and less surprised by weird tax liabilities.
[i] The difference between bitcoin and Bitcoin Cash is technical and seemingly innocuous (and apparently involves something called a "hard fork"), but basically the new bitcoin system can process exchanges much faster. This is either a marvelous advance or invites the doom of the entire concept, depending on who you ask.
[ii] Or 90 days for preferred stock.
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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.