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Special rules for leveraged ETFs

  • J.K. Lasser logo J.K. Lasser
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Leveraged exchange-traded funds (ETFs) are a way to experience dramatic results from small moves in the marketplace. These investments, which Fortune called “a daytrader’s dream,” are not for the average investor—they are more complicated, involve more risk, and can potentially have unintended tax consequences. There are about 250 leveraged ETFs that are being traded currently.

How leveraged ETFs work

Leveraged ETFs are ETFs that use financial derivatives and debt to amplify the moves of the underlying index. Amplification can be two or three times the amount of the underlying index. Here is a simple example (which does not include the effects of daily rebalancing and compounding): Assume an ETF index with a 3:1 ratio (debt to equity) moves up 1%. The leveraged ETF will move up 3%. Of course, the investor does not earn the entire 3%, which is tapped for management fees and other ETF costs. And if the index drops by 1%, the investor has a 3% loss.

Unlike basic ETFs, instead of owning the shares or other securities that the index is comprised of, a leveraged ETF owns options and a pool of cash to track the index.

The term “leveraged ETFs” may also be used to include “inverse ETFs,” which are similar. Like leveraged ETFs, they include derivatives. However, they are designed to profit from a decline in the value of the underlying index.

Potential tax implications for leveraged ETFs

In understanding the taxation for investors in leveraged and inverse ETFs, separate the discussion between the tax on distributions to investors while shares are held from the tax on the sale of the ETF shares.

Distributions:

The leveraged or inverse ETF may make taxable distributions to investors. The investor’s holding period in ETF shares does not affect the tax treatment of these distributions. The ETF will report to investors what portion, if any, of the distributions are short-term capital gains, long-term capital gains, or ordinary income. Most distributions will be short-term capital gains or ordinary income (income generated on its pool of cash).

Since 2013, high-income investors may owe an additional Medicare tax of 3.8% on net investment income (NII tax), which includes ETF distributions.

Sales and other taxable distributions:

Generally, long-term capital gains are taxed at no more than 15% (or zero for those in the 10% or 15% tax bracket; 20% for those in the 39.6% tax bracket since 2013). Short-term capital gain is taxed at the same rates applied to your ordinary income. However, only net capital gains are taxed; capital gains can be offset by capital losses before applying the tax rates. For some leveraged ETFs, gains may be taxed at rates other than the 15%/zero/20% rate; information on tax reporting is provided by the ETF to investors plus the NII tax if applicable.

Note: When you own ETFs in a tax-deferred account, such as an IRA, there is no immediate taxation on any distribution from the ETF or from the sale of shares in the ETF. When funds are distributed from the IRA, all distributions are taxed as ordinary income, regardless of what holdings and transactions generated the funds. However, IRA distributions are not subject to the NII tax.

Conclusion

Leveraged ETFs raise the stakes on investing. The returns can be high, but so can the losses and tax costs. Before investing in a leveraged ETF, be sure to understand how they work and how their taxation can impact your personal tax picture. Work with a knowledgeable financial advisor to provide guidance about leveraged ETFs.

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Article copyright 2011 by J.K. Lasser Tax Institute. Reprinted and adapted from J.K. Lasser’s Your Income Tax 2012 with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint.
The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.

Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

ETFs may trade at a discount to their NAV and are subject to the market fluctuations of their underlying investments. ETFs are subject to management fees and other expenses.
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