What Is the ETF Tax Loophole and Is It Used to Avoid Capital Gains Tax?

No matter how you make money, it’s important to consider the tax implications. Like any source of income, gains from your investment portfolio are subject to taxes. 

Of course, as an investor, it’s important to make moves that ensure tax efficiency. That’s why strategies like tax-loss harvesting exist. 

However, there’s one asset that, thanks to a major tax loophole, often results in zero taxable gains while producing meaningful returns for investors. And it’s not some exotic asset only a select few investors know about. The tax loophole relates to the highly popular exchange-traded fund (ETF)

What Is the ETF Tax Loophole?

The ETF tax loophole is enjoyed by exchange-traded fund investors whether they realize it or not. The loophole is the result of a Nixon-era tax law that made it possible to avoid a requirement to pay capital gains taxes on certain mutual fund transactions. 

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To be exact, the 1969 tax law stipulated that when investors wanted to exit their mutual fund positions, they wouldn’t have to pay taxes if they were paid in stock rather than cash. This loophole was rarely used because most mutual fund investors want cash when they exit their positions, and they are willing to pay the tax bill associated with that decision. 

However, due to the structure of an ETF — a bucket investment similar to mutual funds that was developed in the 1990s — the tax situation is very different. 

Mutual funds are sold directly to investors, whereas ETFs are sold through third parties like brokers and investment banks. These financial institutions are far more willing to accept shares of stock over cash than individuals, leading to the widespread use of this loophole. Today this practice is commonplace on the ETF scene.

How the ETF Tax Loophole Works

When you purchase shares of an ETF, you do so through your broker or investment bank. However, the bank doesn’t send your money to the fund manager. Instead, these funds move up and down in value as investment banks and brokers add stock portfolios to the fund or take them away through processes known as creating and redeeming. So cash transactions simply aren’t the norm. 

Because these banks — the middlemen between you and the ETF itself — work largely in stock rather than cash, they don’t have to pay tax on the vast majority of their redemptions. So, while ETFs may have similar inflows and outflows of investment dollars to mutual funds, and they invest the money in many of the same ways, ETFs are shielded from much of the taxes experienced on mutual fund investments.  

Are ETFs Cheating the System?

Many believe fund managers, investment banks, and brokerages are cheating the system in a significant way by using this loophole. Not only are these funds able to avoid most taxes associated with their normal investment activities, over the past few years some funds appear to have found a way to take further advantage of the rules. 

ETFs seem to be able to avoid even more taxes through partnerships with investment banks and brokers, using events called heartbeats. According to Bloomberg, when a fund needs to exit a position, but doesn’t have an exiting investor to give the shares to, the fund calls a friendly investment bank and asks them to create extra withdrawals by rapidly pumping assets into and out of the fund. 

The rapid creation and redemption creates a pattern on the chart that looks like a heartbeat. It also creates an opportunity for the fund manager to offload shares in exchange for other shares to take advantage of the loophole and avoid a high tax bill. 

The World’s Largest Investment Companies Have a History of Heartbeat Transactions

While heartbeat transactions are off-putting to many in the investing public, to say the least, it seems as though the world’s major banks and brokers all use them. Bloomberg notes ETF managers like Blackrock, State Street, and Vanguard Group all use heartbeat transactions to reduce their tax burdens. They point out banks like Bank of America, Credit Suisse Group, and Goldman Sachs Group help to facilitate these transactions. 

Asset managers attest that heartbeat transactions aren’t being made for tax advantages, but to keep markets fair and equitable. According to the top dogs at many of the investment banks taking part, it’s all about volatility

When a fund needs to offloat a big chunk of a single stock, doing so all at one time would lead to dramatic declines. On the flip side, a massive buy all at one time would lead to tremendous gains. So, the funds say they use heartbeats to avoid these big price swings and keep volatility at normal levels. 

Criticism of the ETF Tax Loophole

The ETF tax loophole helps keep the costs of these funds low for their investors but is not without criticism. At the end of the day, taxes would be cheaper for most individuals if big-money funds paid more tax revenue into the system. Many argue that the ETF tax loophole is just another way for the rich to pay less than their fair share. 

Now, more than ever, tax revenue is crucial for the United States. President Biden and Congress have major policy agendas in the works that will cost massive amounts of money to achieve. The government can raise that money in one of two ways: either they’ll have to raise taxes for all, or close tax loopholes that allow some taxpayers to avoid paying their share. 

That’s why it comes as no surprise that there’s legislation in the works to address the ETF tax loophole. According to CNBC, Senate Finance Committee Chairman Ron Wyden (D-OR) proposed a bill in September 2021 that would close the loophole. If the bill passes, fund managers, brokers, and investment banks will no longer be able to take advantage of tax-free in-kind transactions. 

Other Tax Benefits of ETFs

Although the ETF tax loophole may disappear relatively soon, ETF investors still enjoy other tax advantages that are both effective and fair. The two biggest breaks include:

Fewer Taxable Events than Mutual Funds

Mutual funds are often actively traded funds, meaning shares of stock are generally held for less than a year. Due to the short-term nature of the holdings, the profits generated from trades are taxed at the standard income tax rate

ETFs are different. In most cases, ETFs are designed to track a specific benchmark, and activity within the fund is relatively minimal. For example, an ETF that tracks the S&P 500 only needs to sell its holdings when the makeup of the S&P 500 index itself changes, like when a company drops off the index.

As a result, the vast majority of holdings in these funds are held for longer than a year, meaning investors pay a lower capital gains rate on their profits. Not to mention, with fewer sales, there are fewer taxable events, offering a major advantage. 

How Dividends are Taxed

ETFs also come with a benefit in terms of how you’ll pay taxes on dividends. If you own the fund for 60 days or more prior to the issuance of the dividend, the payment will be referred to as a qualified dividend payment, carrying a tax rate of between 0% and 20%. Dividends on newer holdings will be taxed at your standard income tax rate. 

Final Word

The ETF tax loophole is one reason investors in these funds pay very little in taxes, but it’s not the only reason. Although there is a push to close the shares-in-kind loophole, and that closure may happen, the fact that fewer taxable events take place and qualified dividends are taxed at low rates will ensure that ETFs continue to provide attractive tax advantages regardless. 

Nonetheless, even with the tax advantages, it’s important to remember that all ETFs are their own animal. When choosing a fund to dive into, it’s best to do your research

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